New rules have created a research headache for fund managers
Who should pay for the research fund managers use when making investment decisions? This is the question being asked on the back of new EU proposals that have created a conundrum for asset managers.
Under draft rules published by the commission, the EU’s executive arm, last month, the fund industry’s decades-long practice of lumping together the fees they pay investment banks and brokers for research and trading will come to an end.
Instead, for the first time, asset managers in Europe will have to make it clear to investors exactly what they are paying for.
“It is a big deal for asset managers,” says Uner Nabi, an executive director at EY, the consultancy.
The rules form part of the forthcoming Mifid II regulation. They are widely expected to shine a light on the value of research, which typically includes written reports from bank analysts and getting access to meetings with the management team of public companies.
All the asset managers contacted for this piece, including BNP Paribas Investment Partners, the French fund house, Allianz Global Investors, the fund arm of the German insurer, and Union Investment, the €252bn asset manager, say they are still deciding how they will react to the proposed changes.
They are not alone. Sean Tuffy, head of regulatory intelligence at Brown Brothers Harriman, the financial services company, says: “Managers are still trying to get to grips with what the new world will look like.”
As well as affecting asset managers, the proposals are likely to have a big impact on investment banks, brokers and research companies. Some banks, including Japan’s Nomura, have already begun scaling back their research arms, as the business of providing research becomes less profitable.
But the rules should be good news for investors, who will have greater insight into traditionally hidden fees and charges.
The new transparency will force fund companies to pay more attention to the cost and value of research, which is likely to push prices down over time and eventually lower the charges that are passed on to investors.
The proposals are also expected to prompt some fund houses to stop charging investors for research.
“[The draft rules] have put a spotlight on what exactly people are paying for,” says Adam Toms, chief executive of Instinet Europe, a broker. “That transparency may well lead to further pressure for managers to pay for research themselves.”
According to an EY poll of around 100 asset managers, a quarter of fund houses will stop charging clients for research on the back of the proposals, taking on the costs themselves.
Some asset managers, anticipating an overhaul of the research market, have already done this, including Neil Woodford, the UK’s best-known fund manager, and Baillie Gifford, the Scottish asset manager.
“We are acutely aware that it is investors’ money, not ours, we are investing,” Craig Newman, chief executive at Woodford Investment Management, told FTfm last month.
“Research costs are a function of our role and we believe it is only right that Woodford Investment Management, not our investors, pays for it.”
A rise in the number of asset managers paying for research themselves has been welcomed by consumer champions, who have long argued that fund companies should not be passing the cost of research on to investors.
“Fund managers should be required to bear all the [research and trading] costs involved in fund management,” says Mick McAteer, co-founder of The Financial Inclusion Centre, a think-tank, and a former board member of the UK financial regulator.
The new rules do not require this. But they do require asset managers to end the practice of “bundling”, whereby investment banks and brokers offer asset managers research for “free” in exchange for carrying out trades.
More recently, some asset managers have moved towards commission-sharing agreements, where they pay a broker to execute their trades and ask that broker to allocate a portion of that payment to a research provider.
Under the new proposals, asset managers will have to set up a separate research payment account that is funded in advance and not linked to the volume of trades that are executed. Commission-sharing agreements will subsequently “lose their commercial attractiveness”, says EY’s Mr Nabi.
These changes are pushing some asset managers to consider paying for research themselves, although research experts point out that commission-sharing agreements are likely to remain the norm for many global asset managers.
This is because the practice of sharing commission, in various forms, is common in many countries, including the US.
Elizabeth Corley, vice-chairman of AllianzGI, is among those asset managers who believes it will be difficult to follow Mr Woodford’s lead and stop charging clients for research, as her company is more international.
She says: “[Mr Woodford] has a single fund, focused on the UK, where he has extraordinary access to companies. You have to question whether he really needs any research. He doesn’t have to worry about the US or Japan or Asia or Europe.
“With that single-fund focus and single-jurisdiction focus, you have more ability [to stop charging for research]. We would hesitate to make [a similar] decision because we are a global company.”
She adds that a lack of transparency from big investment banks around the true cost of research and trading is another factor holding large fund companies back from paying for research themselves.
Her concern is that banks might raise the cost of executing trades to make up for a drop in demand for their research reports once the true value of those reports is made clear.
“We are very keen to see an unbundling of the cost [of research and trading] from investment banks. We have been talking about and asking for that for some time.
“If we [got that] unbundling from the investment banks, that would be a huge step forward,” she says.
“What we would not want [is to begin paying for research ourselves], and then find that our trading costs across the market have inflated by a magical factor. We would be very upset about that.”
Other asset managers appear unsure about the best approach to paying for research. Only 15 per cent of managers polled by EY said they would continue to use these commission-sharing agreements based on the rules as they stand. More than three-quarters were undecided about their next steps.
But Nick Thomas, a director at Baillie Gifford, which stopped paying for research earlier this year, says more asset managers will opt to pay for research themselves.
“We have had a few questions from other asset managers, [who] asked to talk about how we did this. I suspect we will see [asset management companies paying for research] gain traction,” he says.
Mr Thomas is also unconvinced that it is more difficult for a global asset manager to pay for research itself than for a small fund house that focuses on one market. He points out that Baillie Gifford runs £123bn of assets across global equity, fixed income and multi-asset funds for an international client base.
He says: “Paying for research internally is much simpler. You need a much more detailed mechanism of proving the value of what you are paying for [if you charge clients for research]. Rather than building a big infrastructure to do that, we took [payments for research] in-house.
“There was no huge cost [to Baillie Gifford]. We had no difficulties in removing that cost from clients’ bills. This means the operational costs [charged to clients] are lower.”
All change in the EU: Traditional commission-sharing model ditched
A commission-sharing agreement allows an asset manager to make one payment to a broker or investment bank to cover both trading and research costs.
Under the current system, a fund manager will pay a broker a percentage of the value of a trade being executed. For example, a fund manager might pay 15 basis points to sell 1,000 shares of company X.
Of this 15bp, 5bp might be used to cover the costs of trading, while the broker might allocate the remaining 10bp to pay for research, often from external research providers.
The percentage of execution fees used to pay for research is set out in the commission-sharing agreement.
Jeremy Davies, co-founder of RSRCHXchange, the research company, says that under proposed EU rules, asset managers will no longer be able to use the traditional commission-sharing model.
Instead, the amount a fund manager pays for research cannot be linked to trading volumes. But a modified commission-sharing agreement, where the fund manager still makes just one payment, can still be used.
Under this model, the fund manager would continue to pay 15bp, for example, when executing a trade. Five basis points would be used to cover the trading costs. The remaining 10bp would then be moved into the new research payment account.
However, the cost of research has to be budgeted in advance under the proposals.
This means that once the fund manager has reached the limit they have set for research costs, the fund manager and broker would have to move to an execution-only rate.