The following is Part 1 of a two-part guest article by Neil Scarth, Principal of Frost Consulting (www.frostconsulting.co.uk) which provides customizable research budgeting/valuation frameworks and research spending databases.
At the request of large asset managers, the FCA is harmonizing the new research optionality rules between MiFID II-scope funds (PS24/9) and UCITs funds (CP24/21).
Differences in language between the two documents have created a debate about the required aggregation level of research budgeting. PS24/9 requires budgeting at a level “appropriate to a firm and its clients” (formerly strategy level) versus the CP24/21 language that, until further clarification, requires fund-level budgeting to avoid cross-subsidization. Some managers are arguing that the PS24/9 language allows the use of firm-wide research budgets.
Two key points are lost in this debate:
- The overarching requirement to allocate research costs fairly between clients means that managers can only operate firm-wide budgets if they have only one fund.
- The critical issue for managers funding research via P&L is not whether fund-level research budgeting is possible (it is – easily), but which research funding method (manager P&L or asset owner funded) ensures that the manager will be globally competitive, regardless of market conditions.
Regulatory Backdrop
The simultaneous Bear markets in equities and bonds in 2022 was a (negative) epiphany for UK/EU governments and regulators. On average UK managers suffered AUM declines of ~20% but a drop in pre-tax profits of 60 – 70%. This is the profit line that must finance both research and ESG budgets.
UK/EU governments and regulators suddenly realized, that for P&L managers, the lower that markets went, the less and less information these managers could access as it was a function of their short-term profitability. Part 2 of the revelation was that this left the UK/EU asset management industries (and their clients) at a substantial global disadvantage versus their US peers, whose research budgets were happily financed by US asset owners.
Armed with this new knowledge, the UK and EU embarked on parallel processes to make it easier for managers to charge clients for research with startling rapidity (by regulatory standards).
Most investors accept that you can’t have your cake and eat it too. UK/EU governments and regulators appear to agree.
From the UK/EU regulators’ perspective, if new regulation makes it easier for asset managers to charge clients for research without their consent, the clear quid pro quo is that asset owners should not have to pay for research products that are not used in the strategies in which they are invested.
Hence the need for strategy level budgets (at the very least for managers running multiple funds). There are easy solutions available for both fund-level budgeting and related cross-subsidization controls.
It is far easier to make the one-time adjustment to Strategy/Fund level budgeting for managers (which increases research ROI) than it is to engage in a protracted struggle with regulators in an attempt to reduce research transparency requirements.
Asset owner and regulatory demands for manager research transparency are no more likely to magically disappear than electronic share trading or Artificial Intelligence. In fact, the US-based Council of Institutional Investors and CFA Institute have recommended to the SEC that UK style research transparency be made requirements under 28e.
Myth #1 – Fund-Level Research Budgeting Is Impossible
Memories are short. In the run-up to MiFID II in 2017 many large managers in the UK and EU publicly stated that they intended to continue to use client money for research despite the requirement for ex-ante mandate level research budgets.
In the fall of 2017 three large US managers opted to pay for research via P&L (for their UK/EU clients only). This prompted the majority of UK and EU managers to follow suit. This does not erase the fact that many large managers were preparing for the fund-level transparency required to use client money under MiFID II. They certainly thought it was possible then.
We can currently identify more than 30 managers who continue to charge UK/EU clients for research. The fact that these managers have >$4 Trillion in AUM and hundreds of UK/EU clients proves that a.) that fund-level research budgeting is possible and b.) that not all asset owners will immediately fire managers who impose a small research charge.
Is the Tail Wagging the Dog?
Much of the commentary on this issue stems from particular constituencies within the asset management community.
Client Service Teams: Are generally reluctant to have a conversation with clients about small research charges. However as one manager put it “If they are going to fire you over a basis point, they were probably going to fire you anyway”.
Operational Teams: May be reluctant to change processes.
What about the “silent” constituencies.
Investment Teams: Almost never want less information and lower research budgets. This is the group that produces the performance numbers that are the lifeblood of any asset management franchise.
Senior Management/Shareholders: Are generally not aiming for below average profitability and higher than average market risks.
It is senior management who will make the ultimate decision and must balance the risk and reward factors for the long-term health of the asset management franchise.
The transcendent strategic question for asset managers is how to reduce unwanted and largely unforecastable market risks from critical research budgets – and if so, at what cost? Click the space below to see the associated chart.
Market commentary has been dominated by concerns about client risk. This seems to ignore the fact that asset managers gain and lose clients, as a matter of course, and for a variety of reasons, on a continual basis. It is part of the natural ebb and flow of the business.
However, the implicit suggestion seems to be that if an asset manager lost a single client over small research charges, it would be an existential threat, and the asset manager would have to immediately shut down. If managers closed every time they lost a client, the industry would be much smaller.
As well as considering the short-term transitory risks on the left above, senior management of P&L managers, whose job it is to maximize the value of the asset management franchise over the long term, should also consider the material benefits on the right above.
Part Two of the Series will examine Client Communication and Risk Mitigation strategies for managers making the transition from research via P&L back to using client money to pay for research.