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.
MiFID II poses an existential threat to European ESG ambitions. As asset managers integrate ESG principles more thoroughly into their investment process, the need for third-party ESG data and research grows. However, MiFID II’s research unbundling provisions constrain asset manager budgets, creating an immense mismatch between the current asset manager funding system and long-term ESG goals. For this reason, pension funds and other asset owners should be incentivized to use their extended duration and low research costs to underwrite long-term ESG objectives. Reform to Europe’s regulatory architecture is necessary to meet these challenges.
MiFID II’s Restrictions
The authors of MiFID II clearly misunderstood the huge research cost asymmetry between asset owners (who previously paid for research costs) and asset managers. The cost to asset owners was small – several basis points — especially compared to equity returns averaging 700 bps. But, when research charges were transferred to the P&L of the asset manager it became their second largest cost, right behind staff compensation.
Consequently, European asset managers cut their research budgets by an average of 50% to 70% to maintain profitability. For pension funds, avoiding de minimus research charges (typically less than 10 basis points) makes little sense when the performance variance between funds that do well and those that do poorly is frequently measured in thousands of basis points.
The Coming ESG Funding Gap
The MiFID II funding regime preceded the widespread adoption of ESG strategies. When MiFID II was being conceived, ESG at the current scale was not remotely visible on the horizon.
Flash forward to 2021: ESG AUM is growing rapidly, but so are ESG data, stewardship and regulation costs. UBS estimates managers spent $2 billion on ESG inputs in 2020 potentially growing to $5 billion by 2025.
European ESG spending may exceed fundamental research budgets before 2025. Both budgets now come from the same place – the manager’s P&L. The two budgets may soon begin to cannibalize one another.
Now, both fundamental research budgets, and long-term European ESG objectives are a function of short-term financial market direction – because they are tied to manager profitability. As long as there is an uninterrupted bull market between now and 2050, everything will be fine…
The Role of Pension Funds
Pension funds have long-term liability profiles that align well with the timeframes required for the achievement of ESG objectives. However, asset managers, measured quarterly, and with annual profit targets, operate in a much more constrained timeframe. The result is an immense funding duration mismatch between long-term ESG targets (such as carbon neutrality by 2050) and the current funding regime.
But, if market volatility is possible over the next 30 years, we must hedge this risk or sacrifice ESG objectives, thereby squandering ESG momentum which has taken decades to marshal.
The following chart plots bull and bear markets in US equities since 1949. Historically, the liklihood of an uninterupted equity advance between now and 2050 seems low – particularly given the starting point.
In addition, European asset managers are far less resilient now than they were in 2007. We estimate that a 2008 magnitude market decline would eliminate manager profits completely, compared to a 40% decline in profits during the Great Recession. This could prove fatal for ESG objectives. No ESG budget could survive this unless asset managers became not-for-profit social enterprises.
The Need for Reform
One solution is to incentivize pension funds, whose liability profiles mirror long-term ESG timeframes, to use their unique characteristics to ensure sustainability. Pension funds should use their long duration and low research costs to finance transparent, benchmarked, fund-level asset manager ESG budgets. In doing so, they would insulate long-term ESG objectives from short-term market volatility, in a way that asset managers, measured quarterly, simply cannot.
This will be the ongoing methodology in the US, which has largely avoided the MiFID II reforms. It would be ironic if Europe, long the leader in advancing ESG goals, should cede its ESG superiority because of a funding gap for sustainable investments.
The cost of MiFID II reform to pension funds would be extremely small while the benefits to society could be extremely large. Many pension beneficiaries might willingly forgo a small portion of short-term return in exchange for longer-term ESG objectives to be sustained.
Moreover, ESG might achieve what MiFID II couldn’t: manager research transparency in exchange for durable asset owner research/ESG funding. Now is the time to have a transparent discussion on ESG funding. Otherwise, European sustainability, good intentions notwithstanding, could prove to be anything but.