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. Frost Consulting recently collaborated with Evercore ISI to update their analysis of the impact of research spending on performance post-MiFID II.
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The post-2008 trend towards worldwide convergence of financial regulation is the most recent victim of de-globalization. The combination of Brexit, a MiFID II review by the EU and the antipathy of the SEC towards MiFID II, ensures the playing field for global research payments – and research access – will not be level. There will be winners and losers, with the gaps between them becoming increasingly difficult for the losers to bridge.
The multi-year debate on research payments is about to culminate in a pivotal negotiation between US asset owners and US asset managers, the result of which will have profound consequences for all global market participants – and may well be beyond the control of the SEC.
MiFID II has been a wake-up call for US asset owners based on the disparity that while many US managers are paying for research via P&L for European clients, they continue to charge US investors. In response, US asset owners (and other industry bodies) have recommended that the SEC maintain the current research commission system with the proviso that asset managers: 1) disclose the quantum of research payments at the fund/client level; and 2) demonstrate that the asset owner’s research commissions are being used for its portfolio alone – not for other investors. (No cross-subsidization)
This will require US managers to create ex-ante research budgets at the fund/strategy level and map specific research services to them.
US managers have an opportunity to provide transparency in order to continue to use billions of dollars of their clients’ money on research, enhancing both their profitability and global competitiveness. Should they fail to do so, US asset owners may insist they fund research via their own P&Ls – regardless of the wishes of the SEC.
The Gap in Research Spending
The FrostDB research database suggests that there are immense gaps in research spending between US (client money) and European (P&L) managers.
On average, for example, US managers are spending 4.1X the amount on research for global equity mandates versus European managers. The gap is wide enough to have a material impact on the amount of information made available to the respective investment teams. The biggest divergences appear in the most research-intensive categories including small-cap and emerging markets. There are also immense gaps in research spending between P&L managers themselves (up to 15-fold in some categories).
Research Costs Are Dwarfed by Differences in Fund Performance
Frost Consulting has updated work originally done in conjunction with Stanford University examining the relationship between the cost of research for asset owners (normally < 10 bps.) and the variance in fund returns. This should be a major factor in asset owner deliberations regarding research funding models and may explain why US asset owners are currently willing to consider continuing to pay for research if their transparency requirements are met.
Across 16 equity categories, the average difference between mid-1st and mid-4th quartile performance (in the red boxes) averaged 1,500 bps. This is a vast multiple of any conceivable research budget. The total range per category frequently exceeded 4,000 bps.
Impact of Research Spending on Performance?
Frost Consulting has partnered with Evercore ISI to examine multi-year performance trends of funds in like-for-like categories (US, Equities, Emerging Markets, ESG etc.) run by both US and European managers. (~5,000 funds with AUM of ~$10 trillion) The data captures both pre-MiFID II (pre-2018) and the aftermath when trans-Atlantic research spending gaps became very pronounced.
US managers have harvested the bulk of the outperformance over the survey period. While a myriad of factors contribute to performance, we believe that research is an important input. Market direction appeared to have limited impact. In 2018 the MSCI World Index was down 8.2% followed by a 28.4% rebound in 2019.
The chart above indicates that US managers outperformed in the vast majority of sectors. In aggregate in 2019, the US outperformance totalled 265 bps. – roughly $245 billion. This compares to an estimated $6.2 billion of asset owner research commissions spent by US managers on external research.
Binary Outcomes
Without doubt, most US asset managers will have to adjust research valuation/budgeting processes when US asset owners demand greater research transparency in return for the continued ability to use client money for research.
The good news is that this is easily achievable. (Frost has simple, cost-effective solutions to generate fund/strategy top-line budgets and solve transparency/cross-subsidization issues. This process meets all global regulatory requirements and US asset owner “Best Practice” specifications yet require almost no time from investment professionals).
The alternative would be a major hit to profitability. McKinsey estimates that US-based active equity strategies had aggregate revenues of $55.8 billion in 2018. Assuming a 30% operating margin would yield pre-tax profitability of $16.7 billion. If the $6.2 billion in US research spending were transferred to the P&L of the asset managers, this would represent a ~ 37% hit to profits. Assuming a 50% cut in the research budget would still suggest a ~19% profit decline.
In light of the European experience, senior managements of US asset managers should pro-actively make the research transparency decision on behalf of their organizations. The economic and competitive implications are immense. This is not a decision that should be determined by the short-term operational convenience of the middle office.
The Impact of Covid-19
Finally, the Covid pandemic offers a sobering lesson in the relative and absolute risks of the P&L method.
In the US, research budgets are correlated with equity turnover (+ 40% YTD), resulting in sharply higher research spending. In Europe research budgets are correlated with the pre-tax profitability of P&L managers. Declining index levels rapidly translate into lower manager AUM. This quickly reduces revenue. Asset manager costs can rarely adjust as quickly. So, for European P&L managers whose AUM is down 10 – 30%, pre-tax profits will fall by a greater percentage (30 – 50%). That is the account from which the research funding has to be sourced.
Ironically, the lower markets go, the less research P&L managers will be able to access. Is that likely in the interest of their clients?