Frost Consulting, a London-based consulting firm focused on commission unbundling, launched a research budgeting platform designed to supersede the existing broker vote process. The approach represents a radical departure from existing research payment practices.
The new service, FrostRB, generates research budgets down to the fund level, reflecting the fund or strategy’s investment process, style and investment universe. The approach is to focus on the alignment of research with portfolio requirements, rather than on price. The system is premised on the belief that budgeting and research payments should be extension of portfolio construction.
How budgeting works
In a recent interview, Frost principal Neil Scarth explained that budgeting is a two-step process. First, CIOs and portfolio managers establish the relative weights for each fund based on its portfolio construction taking into account the strategy, regional or sector weights.
The next step is to determine which research is most relevant by asking analysts and portfolio managers to rate the relevance of each provider’s research to their investment process. If two healthcare providers are equally rated, there is no reason not to pay them the same.
Once product level value is established, it can be aggregated up to the research provider level to determine the overall amount paid to the investment bank or independent.
The process seems complicated because it is more granular than traditional broker votes. However, Scarth believes the system is easier for investment professionals because it is aligned with the way they construct portfolios:
“Many are confused about pricing research. We have an answer. The right price of research is the amount you have to spend on external research for your investment strategies to deliver returns to your end investors.”
In Scarth’s view, current research commission allocation techniques, including broker vote systems, are too imprecise to support research budgeting at the fund level or establish value for individual research products.
FrostRB maintains that broker vote systems can result in over-payment for research that managers intend to use, generate implicit payments for products that aren’t used, and raise cross-subsidization issues between funds. These inefficiencies reduce returns for asset owners.
The core problem is that the broker vote is focused on bank level allocations which do not deliver the detail needed to value research. Research valuation needs to get down to the sector and regional basis.
The FrostRB methodology is designed to be multi-asset. Fixed income research has historically been viewed as ‘free’ because there have been no explicit charges for bundled fixed income research. However, in Scarth’s view, fixed income funds such as high yield corporate bond funds have requirements for research even though they have not historically paid for it.
Under the FrostRB framework any asset class portfolio can receive a research allocation. Until now, fixed income funds have benefited from cross-subsidization from equity funds. Going forward, fixed income funds should pay for the research consumed in Scarth’s opinion.
Changed internal dynamics
Budgeting will potentially have significant impact on internal research allocations as well as external payments. If there are two similar sized funds with similar investment strategies, their research payments should be similar even if one has five times the turnover of the other.
That is not how things work now, and some PMs will find that they are allocated less research budget under FrostRB than in a bundled environment. As Scarth points out, if you eliminate cross-subsidization, there will be winners and losers.
Scarth believes that research budgeting will become a competitive differentiator for asset managers. Asset owners will increasingly benchmark research spending.
He sees sovereign wealth funds as one class of asset owners who are particularly attuned to research budgeting. Sovereign wealth funds are implementing internal budgeting for their own funds and therefore understand the issues associated with cross-subsidization across funds.
According to Scarth, several clients are currently being onboarded. The firm is in discussions with potential redistributors.
Fees for the platform are based on the number of investment professionals, the frequency of the budgeting exercise (annual/quarterly), and the number of budgets (an asset manager specializing in one strategy, region or sector will have fewer budgets than managers with broader investment approaches).
FrostRB has also hired additional staff as part of the budgeting launch. Thomas Auschill, based in Frankfurt, joins the firm from equinet Bank AG where he was a member of the Executive Board. He previously headed client account management in Europe for Macquarie.
Quentin Millington, who held various roles at asset management and sell-side firms directing IT transformation, will oversee development.
FrostRB is based on an elegant core philosophy which is aligned with asset managers’ investment processes. Even better, the system is compatible with the asset owners’ mandates that drive the investment processes. The platform is fully in sync with European regulatory imperatives for research payment reform.
The challenge is that the process is a major departure from status quo. As such, the FrostRB approach to budgeting may lead to large changes in research payments to external providers, potentially upsetting major suppliers. Moreover, it may shift internal research allocations significantly. Some PMs may find that they no longer have the wherewithal to keep all their existing research providers happy. By definition, eliminating cross-subsidization will hurt some funds and help others. Given the potential politics involved, budgeting will need strong top-level leadership.
The dilemma for asset managers is whether the disruption will pay off in more assets under management. Sophisticated clients like sovereign wealth funds will approve, but what about the others? Ultimately, the level of change implied by proper research budgeting will need be client driven not regulatory driven, and it is still unclear how asset owners will react.