The below market commentary was written by Eric W. Noll, Convergex CEO
MiFID II, an upcoming piece of legislation from European Union regulators, upends the traditional linkage between trading commissions and investment research in ways both the money management and brokerage industries have yet to fully understand. It will force both the explicit pricing of sell-side research and the defense of those expenses to asset owners by money managers. Moreover, while this is an EU directive, we expect many global asset owners to eventually embrace its core principles of explicit pricing and transparency. By virtue of our market leadership in the Commission Sharing Agreement business through Westminster Research, we stand ready to offer solutions and act as a guide to our money management clients as they face these new challenges.
“Half the money I spend on advertising is wasted; the trouble is I don’t know which half.” That century-old quote from John Wanamaker, one of America’s most famous merchants, is as true today as it was in his time. Every business knows they have to advertise to attract new customers and retain old ones, but even in the Internet Age the advertising game remains – at best – an imprecise science.
There is a close analog living on Wall Street: the value of the sell-side equity analyst. Every Director of Research knows that half of their firm’s analysts generate most (if not all) of the aggregate profitability of their team. Sometimes that is because the analyst in question has a history of great calls. Other times, it is because they run the best-attended conference in the sector. In still other instances, it is just “right place, right time” – a solid analyst who happens to cover a sector that has gotten hot of late.
On the investment management side of the business, Wanamaker’s adage has similar relevancy when it comes to the research these asset managers purchase from those brokerage firms. Half – if not more – of the content a portfolio manager/analyst receives from the Street is perceived to have little-to-no value. Sometimes that perception is based on the principle that it is simply not value-added work, and sometimes that the research addresses a company or sector that is currently out of favor. That is an important difference of course, even if it does not change the 50/50 calculus.
This is all about to change, and the catalyst comes from the European Union with its Markets in Financial Instrument Directive (commonly called MiFID II). Set to take effect on January 3, 2018, it requires investment managers to rethink how they pay for brokerage firm research. No longer will they be able to bundle commission payments for trading execution and research services. After January 3, 2018, if they want to purchase brokerage firm research, there are just two options:
- Pay for it in cash from the earnings of the money management business itself.
- Set up a Research Payment Account (RPA), to be funded either with an explicit fee charged to the investment firm’s clients or with commissions explicitly carved out of trading executions. The RPA will need to be structured strictly in accordance with the new regulations as well as require the asset manager to create a research budget for the year ahead, apply appropriate quality assessments to the research being consumed and report research expenditures to its clients on both an ex-ante and ex-poste basis.
That might all sound innocuous enough, but once you think through the ramifications it becomes clear that big changes are afoot. For example:
- Under either approach, asset managers will want to know exactly what they are paying for and how much it costs. When was the last time you saw a hot-off-the-press research report from a top tier analyst with a price tag printed on the cover? Never. But under MiFID II it is coming. And coming fast.
- If an asset manager chooses to use an RPA, they will have to budget their research expenses (and stick to that budget), actively manage those expenses and provide transparency to the asset owner about what resources they use and how much they cost.
Take a moment and consider the ramifications of these changes. Here are just a few novel questions and issues they raise:
- What is the process to develop a research budget? Do you just look at trailing expenses? Or do you try to forecast future market volatility and anticipated sector correlations, which may provide more investment opportunities but also require the purchase of more resources? And how much do you allocate to macro research (which has been a must-have over the last decade) versus stock-specific work (because correlations now appear to be in secular decline)? Outperforming a benchmark is tough enough; now, you might need to forecast which resources you will require before it is obvious that you will need them.
How does the sell-side develop a service menu to help their clients budget their research spends? Over the decades, brokerage firms have refined a dynamic pricing model that enable them to essentially charge different prices to different customers for the same product, all the while looking to capture every bit of potential revenue. Now, clients will want to know exactly how much a report or an analyst visit or a conference will cost. It’s like going from a family-style buffet restaurant to a dining establishment with a la carte pricing.
- While this is currently an EU-only mandate, how will it change both the creation and consumption of research in the U.S. and elsewhere? Once asset owners see the process start to take hold in Europe, they may well ask their managers in other markets for similar disclosures. MiFID II could well become a global standard for research pricing and disclosure, even if the actual payment mechanisms (commissions in the U.S., for example) remain unchanged.
While U.S. based asset managers may not necessarily have to comply with MiFID II, it is important to emphasize that we anticipate this directive will ultimately have a global impact as it is now virtually impossible to contain regulation within geographic boundaries. As global managers do business with European asset owners, they may ultimately make a decision to adapt their current procedures to give them the operational capacity to respond to the MiFID II Directives and err on the side of caution.
Now, if you want a playbook for how all this looks, we have it. Our Westminster Research Associates business has been around for 20+ years, helping clients with exactly the sort of challenges they will face with MiFID II. For example:
- Westminster processes hundreds of millions of dollars every year in payments on behalf of clients. Every single bill they pay has an explicit price for the research resources used by our clients. Every research provider you can imagine accepts these payments, from top tier brokerage firms to data providers and bespoke resources that may only have one or two clients.
- The Westminster team also acts as consultants to our base of 700+ clients, helping with everything from uncovering hard-to-find research resources to efficient bill-paying and CSA account reconciliation. In a post-MiFID II world, this allows clients to see the full landscape of resources and better understand what is a “fair” price for the services they receive.
- Westminster is currently enhancing its market-leading systems and processes to dovetail seamlessly with MiFID II’s concept of a Research Payment Account. In fact, Westminster has been preparing for the MiFID II Directives since early 2016 and has the ability to work with any software provider to offer a comprehensive RPA solution to its clients. The spirit of both the current CSA paradigm and the RPA approach are sufficiently similar that we believe the solutions offered by Westminster can add considerable value as clients make the transition to the new regulations.
In summary, MiFID II may be an EU regulation but it will almost certainly change broker-provided investment research around the world. We see that as a positive development because with greater transparency will come more accountability and, ultimately, a more efficient research marketplace. Clients will get more of what they want – truly differentiated research that helps them perform – while tracking what that resource costs and explicitly evaluating its cost and benefits.
Will this be an easy transition? Of course not, but we are focused on making all of the necessary changes to our business model to meet the MiFID II requirements that will enable our clients to respond effectively to the new environment. The quote with which we started this note mentioned that half of all advertising is wasted. It could well be that half of all broker research is unwanted. Only time will tell. But with MiFID II on the horizon, we are on the road to finally determining which half is truly valuable. And that is a journey worth taking, both for brokers and for asset managers.