Neil Scarth of Frost Consulting, a UK-based consulting firm specializing in global commission unbundling, forwarded some interesting estimates on sell side research spending. Frost Consulting projects that global investment bank spending on research will have declined from $8.2 billion in 2008 to $4.8 billion in 2013, a 42% decline. This decline is structural, not cyclical, and has implications for all research industry participants.
The research payment process is arcane. Since investment bank research is paid through client commissions, there is little pricing transparency for brokerage research. The payments represent a negotiation between investment banks and asset managers. There is cajoling, wheedling, some threatening. For years, investment banks have threatened to reduce services to asset managers if asset managers don’t allocate more commissions. The threats were so common and so rarely enforced with larger asset managers that most asset managers became inured to the threats. But now it is really happening, and at an industry level. Investment banks aren’t cutting off clients, they are dramatically cutting their research, period.
The slide below, courtesy of Frost Consulting, shows the estimated decline in investment bank research spend (red line.) The blue bars represent the rising portion of commissions being allocated to commission sharing arrangements (CSAs, also know as client commission agreements in the U.S.). The point of the slide is that asset managers are increasing their use of CSAs partly in response to the declining investment banking spending. And those asset managers who aren’t using CSAs, should.The decline in banking research spend represents a quandary for asset managers. The decline is caused by the fall in commissions as asset managers reduce their turnover and improve their management fees and expenses. Active asset managers are threatened by the dramatic rise in ETFs. ETFs received $191 billion in new assets in 2012, while US stock funds saw withdrawals of $82 billion as of September. US ETF assets stand at $1.35 trillion, which is still smaller than the $3.5 trillion in US equity fund assets, but the ETF assets are growing quickly.
The commission decline partly reflects a competitive response to the rise of ETFs, and we can expect the continued pressure on active managers to keep commissions lower. Increasing overall commission spending to fund external research is not a viable option. We believe asset managers have increased their commission allocations to investment banks at the expense of independent and smaller brokerage research, but this only goes so far.
The response from investment banks, which rely primarily on commission payments to fund research, has been to cut research spending. We have heard rumors that one major bulge firm has cut their research budget from $800 million to $150 million. The question is how much is enough. Coalition, a UK based consulting firm specializing in investment banks, estimates that the productivity of cash equities is among the lowest of all investment banking products. Cutting research spending improves the productivity, but if commissions continue to languish, there will likely be more cuts.
Where does this leave independent research? In the short run, independent research is getting squeezed as asset managers try to soften the blow to bank research by allocating more of the shrinking commissions. Nor is independent research immune to the overall pressure on active asset managers from passive alternatives. In the medium and longer term, independent research is competitive because of it lower cost base and its diversity. The challenge is getting from here to the medium to long term…