The following is a guest article by Neil Scarth, Principal of Frost Consulting (http://www.frostconsulting.co.uk/) which provides customizable research budgeting/valuation frameworks and research spending databases.
The prevailing consensus of opinion in June 2017 regarding the likely shape of the post-MiFID II environment — shared by regulators, asset managers, and industry commentators alike — has been, for the most part, dead wrong.
Instead of most asset manages continuing to use client money for research, the majority of large European managers have (in many cases reluctantly) opted to use P&L owing to perceived competitive pressure.
Combined with significant research budget cuts by P&L managers (Credit Suisse estimated 50% on average), this will likely result in further unanticipated consequences – for all market participants, including asset owners.
An obvious lesson from the financial crisis that somehow seems easily forgotten is that “Nobody really knows how interconnected things are until you break them”. We’re finding out.
The P&L decision by many managers, combined with the ferocity of asset manager compliance departments in a yet to be determined enforcement environment, has created significant challenges to the investment processes of many managers.
The transition from “all you can eat/everything from everyone” to a more contractual research environment has created outcomes ranging from uncertainty (at best) to havoc (at worst) in terms of the information flow between and within organizations.
European asset managers will need to develop new research operating models, while simultaneously attempting to generate alpha in competition with far less constrained US managers (and passive, of course). Most US managers will continue to fund ~90% of their research budgets in the traditional fashion in the US.
The end of the “laissez-faire” system in Europe, in which managers of widely differing size and commission spending could receive similar levels of research services, is over. This will create an unprecedented “Information Asymmetry” between managers based on their willingness to pay for research.
(Source: Frost Consulting)
Hedge funds and US managers will have the fewest constraints while European managers who implemented P&L policies at the last minute face the greatest challenges to their investment processes. Many managers in this category had fully planned to use client money for research and in many cases had spent months preparing to do so – only to find last fall that senior management suddenly decided to opt for P&L owing to perceived competitive pressure.
This forced the CIO to ask the CFO for a large and unexpected research allocation from a 2018 budget, that a) hadn’t been anticipated and b) was going to begin in a few months’ time. This also meant that internal investment teams were competing for suddenly scarce research budget.
We do not yet know the full impact of Information Asymmetry. However, is seems certain that some managers will have more information than others, and possible that this will be reflected in long-term performance assuming research has any value.
It will certainly increase the risk that the historical performance of investment products may not be sustainable – particularly if those returns were predicated on a level of research access that no longer exits. (Presumably investment consultants will figure this out).
This would appear to favour US managers given their (current) widespread ability to use client funds for research which will result in higher research spending levels and greater spending flexibility. Research producers, most of whom are margin constrained, will be forced to re-allocate capacity to those managers that can pay and away from those that can’t/won’t. European P&L managers are likely to be viewed as “capped” and “ex-growth”.
In addition, there are widespread reports of a “buyer’s strike” for analyst access/meetings from European managers. The sudden transparency that a proposed analyst meeting will cost XX dollars, (and come out of the PM’s bonus pool), has significantly reduced analyst contact – and this is with those research producers that have contracts in place. Research providers without contracts are completely out of luck.
This will have two fairly likely impacts:
- These European managers will get less information.
- Research producers that sought to offset very low document-only access fees by selling certain volumes of higher value-added services, may have to re-visit their assumptions.
US managers may enjoy the “second-mover advantage” as they get a sneak preview of what an unwelcome regulatory result may look like, while simultaneously maintaining at least a short-term information advantage relative to their European competitors.
The fact that the SEC No Action letters of last November have a 30-month limit, means it is likely that there will be a research funding debate in the US. Already some US asset owners have lobbied the SEC that they would also like to pay US banks via hard dollars. In addition, some US asset owners may question why their managers are paying for research via P&L for their European clients, but not for them.
Also, as in Europe, it may be the competitive dynamic that alters the environment to a greater degree than the regulatory change alone would have suggested. If a major US manager elects to pay for all clients globally via P&L, it could alter the landscape quickly.
If US managers want to continue to use client money for research, they would be well advised to demonstrate to asset owners how their de minimis (~5 bps) research spending directly supports the client’s portfolio return objectives (long-term equity returns average ~700 bps per annum).
This will require managers to construct appropriate research budgets at the product/strategy level at which the client is invested and demonstrate research ROI, even if it is not currently required by regulation. A one-off reconfiguration of the existing research budget process, (which takes no time from the investment teams) seems a small price to pay for securing the ability to continue to use client funds for research – particularly in light of the alternative:
The manager facing an existential dilemma of how to balance short-term profitability against research spending that generates medium-term alpha, which in turn drives long-term franchise value.
It seems likely that few US firms would want to subject their investment teams and processes to the radical and rapid re-structuring faced by the Involuntary P&L managers on the Information Asymmetry hierarchy.
In virtually every other business on the planet, demonstrating value for money to clients would seem like second nature. Yet, for some reason in the investment research world, this has been a big challenge for asset managers.
We’re witnessing what a bad outcome looks like in Europe. It is up to senior management at US managers to act now to avoid a similar fate. The stakes are high and the effort/cost required are low.
For active managers who are already challenged to defend their value proposition, being unable or unwilling to demonstrate how their research spending of the client’s money supports the client’s portfolio return objectives, may turn out to be unwise in hindsight.
Many European managers were initially complacent about MiFID II. This rapidly morphed to panic as many felt compelled to choose the P&L option. The one thing they didn’t do was to engage their clients and make the case for how and why the existing research spending regime was in the asset owner’s interest.
The rapid move to P&L was likely predicated on the notion that asset owners would be universally unwilling to deal with managers that weren’t funding research via P&L. This turns out not to be true. A number of smaller UK managers, along with hedge funds and large US managers, are still using client money for research and live to tell the tale.
We believe asset owners are willing to engage with managers using client money, as long the manager can demonstrate how the spending directly supports their investment objectives and is an integral part of the investment process agreed when the investment was made.