MiFID II will have a revolutionary effect on the way that most managers find, value and procure investment research – on a global basis.  This requires the immediate attention of senior management given the rapidly narrowing timelines involved (Jan. 3, 2018) and the economic/ competitive implications of MiFID II policy decisions.

The evolving competitive environment also means hedge funds may receive significant regulatory attention surrounding their research valuation policies if they choose to use client money for research – at least in the UK.  This is because an increasing number of large long-only funds have elected to pay for research via P&L, meaning many of the MiFID II requirements do not apply.  Consequently, hedge funds may be in the regulatory spotlight.

The FCA is expected to systematically request managers’ (required) MiFID II Research Valuation Policies in early January, to guide their further supervisory investigations.

The MiFID II-related changes on the asset manager’s research process will have knock-on effects on:

• The economics of the sell-side research model (resulting in less research).
• The economics of asset managers whose research funding mechanism will have a profound impact on their profitability and competitive positioning.
• The relationship between asset managers and asset owners, who will be directly involved in the research funding discussion for the first time.

Key MiFID II research requirements

If managers are using client money for the purchase of research (either via the accrual (Swedish Model), or via CSA-funded RPAs,), managers must:

• Present finite monetary research budgets to asset owners in advance, based upon the actual investment products owned by the client.
• Have asset owners approve these budgets.
• Demonstrate, on an ex-post basis, which research services were purchased at the portfolio level and how those services benefited the portfolio
• Value unpriced investment bank research services
• Eliminate fund cross-subsidization.
• Use research budgets for all asset classes.
• Produce a MiFID II Written Research Valuation policy (Equivalent of “Best Ex” policy) that specifies the methodology used by the manager to value research and how the manager fairly divides research costs between clients.

From an operational perspective, these requirements represent an immense change from the historically laissez-faire system in which large amounts of sell-side research were ingested with little consideration given to which of it was used or useful and its actual value.  Research payments were via bundled brokerage commission that varied with AUM, turnover and share prices.

Most research commission allocation was done by “broker-vote” systems which regulators have made clear are not sufficient in isolation to meet MiFID II requirements.

The first step is for managers to derive a research budget that meets their needs.  However, the requirement that the budget must be tied to the particular product owned by the client means that, for many firms, a firm-wide budget may not be sufficient if the firm runs multiple products in with differing research requirements (geography/sector/asset class).

Many firms will construct strategy-based budgets of funds which consume similar research with the key determinant being that research costs are allocated fairly to clients.

Firms will have to determine what kinds of research are necessary, which producers of that research are essential, and will then have to value it on a strategy-specific basis.  Regulators, and asset owners increasingly recognize that all strategies do not require the same amount of research or size of research budget.  Consider a small-cap strategy in a limited geography with an investible universe of 200 stocks, versus a global product with a universe of 15,000.

Different strategies may require very different research inputs reflecting their investment process, growth/value/geography/style etc.  Fortunately, the regulators recognize that a research service may be worth very different amounts to different investment strategies.

What is the value of an excellent analyst report of Facebook to a deep value investor?  (Likely not high as the stock is so expensive that value managers would not be allowed to own it).  However, the same product may be critical to a growth investor which has a portfolio dominated by Facebook related thematic investments.

Beauty is in the eye of the beholder.  Managers should be able to identify and value the research services their strategies require, and identify those which they don’t need and therefore shouldn’t spend their clients’ money purchasing.  Frost views the “right” price of research to be – the amount you have to pay to get the external research that your strategies need to deliver their targeted returns to investors.  By definition, if the strategy does not require external research to generate its returns, than none should be bought – using anyone’s money.

However, the vast majority of active equity strategies do require external research, which enhances returns and creates efficiencies for both asset managers and asset owners.  They key consideration in the upcoming presentation of initial MiFID II research budgets to asset owners, is for the manager to demonstrate that the proposed research spending directly supports the portfolio objectives that were agreed when the investment was made.

In this, the interests of the asset manager and asset owner are completely aligned:  nobody wants the investment product to perform as designed more than the asset owner, as it’s in their portfolio and plays a key role in their own targeted return and risk budget calculations.

In the long-term, the global impact of MiFID II will be commercial rather than regulatory.  It is the direct involvement of the asset owner which is the key driver.

If nothing else, MiFID II will permanently change the research transparency expectations of European asset owners – who allocate globally.  By January, European asset owners will have received many research budget proposals from their European managers, some of whom will be running similar mandates.  Which ones will they approve?

In the US, the moment a trustee receives advice from a manager that money is to be deducted from their account for research, it creates an immediate fiduciary responsibility to challenge that proposal or accepted it.  As the European managers of US asset owners deliver proposed research budgets, how are those US clients going to view managers that do not provide that transparency.

Frequently it will be the (compliance-driven) global operating procedures of large managers that roll out MiFID II rules globally, which will alter the competitive landscape in all of the geographies in which they operate.

The implications for asset managers are huge.  If asset owners reject research budgets, managers will have to fund research from their own P&Ls, potentially creating an uncomfortable conflict of interest between purchasing the best research for the client versus firm profitability.  The profitability of some active equity strategies could fall sharply under those circumstances.

These firms will have less research spending capacity, lower profitability and lower external research service levels than firms which do convince asset owners to continue to fund their research budgets.

Further complications can arise if some investors in a co-mingled product refuse to pay for research while others remain willing to do so.

For hedge funds with high fee structures, the disclosure of another discrete costs may be unhelpful – particularly if the fund’s research budget is higher than long only managers.  (Most funds have little idea of how their research spending stacks up against competitors).  They will have no idea how competitors are presenting their research budgets (quantum, level of aggregation) – particularly in directly competing or similar products,

The presentation of initial client MiFID II research budgets in 2H 2017 will be a watershed event for the industry.  Managers will have to:

• Establish a multi-asset class research valuation methodology
• Develop a strategy for the delivery of client research budgets
• Decide how to handle clients that don’t want to pay

Because managers will have no visibility on the approach of their competitors, all they can do is to ensure that their research budgets are aligned with the investment process agreed with the client when the investment was made.

They will have one chance to get this right.  Managers who have their initial research budgets rejected by asset owners will find it difficult to reverse this outcome.

Pension funds in the US are already starting to benchmark asset manager research spending (Research “TCA”) in anticipation of receiving MiFID II research budgets.

Two dominant approaches have evolved to help managers meet this challenge. 

One model, championed by the banks, relies on research product consumption to justify research payments.  This raises a number of issues.  Does the manager value all the research they’ve been sent by the producer?  Does short-term research product consumption equal long-term research value?  (Many analytical relationships take years to develop.  PMs may have important analytical relationships with analysts whose reports they never read).  Do managers want the banks to determine the value of a manager’s research based on unsolicited input from the banks?

An alternative approach values research services based on their expected contribution to risk-adjusted return at the portfolio or strategy budget level.  This ensures alignment between the research budget and the portfolio process that has been agreed with the asset owner.

Critically, it allows the asset manager to value any type or bundle of research services (priced/unpriced/independent/investment bank/consultant) based on the managers investment process, investment products, portfolio construction and the way its investment professionals use research.  This process creates a manager-specific multi-asset class research valuation methodology which allows managers to independently assess increasingly complex and non-comparable bank research price frameworks to establish which are the best fit/value for the manager, given its unique investment approaches.

The primary objective of the first approach is to maximize research revenue to the banks.  The priority of the second approach is to maximize the probability of MiFID II research budgets being approved by both clients and regulators.

If an asset manager and an asset owner have agreed a research budget, and, the manager can demonstrate that the research spending directly supported the portfolio objectives agreed between the two, the role of the regulator is vastly reduced.  In fact, it is eliminated, as their objectives (and those of the client) will have been achieved.

To contact the author:

Neil Scarth, Principal, Frost Consulting: [email protected]