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MiFID II favours Goliaths over Davids

26th September 2017

Private deliberations have recently given way to a flood of funds publicly announcing they will pay for research from P&L in Europe.

The shift to paying for research from P&L will have industry-wide ramifications

Recent announcements from the largest US fund managers have triggered many European managers to announce that they will pay for research from their own balance sheet, rather than from client funds. Some large firms such as Schroders and Invesco have reversed previous public statements that they would continue to charge clients for research directly, and will now pay from their P&L. At TIM, we believe that this change in approach means the new regulations will have a much more significant impact on our industry than previously anticipated. The effects are likely to include:

  • Lower profits for European fund managers, and a particular squeeze on smaller European funds that may suffer outflows, lower profits, lower performance, or all three
  • A decline in payments for research, putting further pressure on broker research departments

Size matters

The large US funds that have led the way may be least impacted as they are paying from P&L only for their EU clients, but mostly keeping the status quo elsewhere (though the European approach to research payments looks attractive to global asset owners, and may push funds to pay for research out of P&L outside Europe). Their research payments are relatively small compared to their P&L because of their scale, and their European operations tend to be small relative to the entire firm. In contrast, large European funds will see a bigger impact on profits and their ability to pay for research, as more of their funds are affected by MiFID II rules.

The greatest impact will be on smaller European funds that must either risk fund outflows if they continue to charge clients for research, or suffer a significant squeeze on profits if they pay from P&L or perform more research in house. If they bring research in-house, performance may change, perhaps for the worse.

Many of these smaller funds are still early in the process of making decisions about payment for research. As responsibility is often delegated to a middle-management MiFID team, different departments can pull in different directions. While investor relations and compliance teams at fund managers push to pay from P&L, CFOs anticipate having a hard time explaining the reduction in profits to shareholders.

Funds that do not fall under MiFID II, such as sovereign wealth funds and family offices are unaffected, and can continue to pay for research through commission if they wish. However, these firms may benefit from lower research costs and tighter execution costs.

Research squeezed

Where funds go the P&L route, it is unlikely the CFOs will be keen to allocate equivalent funds to pay the research dollars previously funded by their clients, with significant impact on the sell-side.

The shift to payment from P&L makes it more likely that research spend will shrink sooner rather than later, by as much as 30% according to research conducted by Oliver Wyman. With a smaller pot, some buy-sides will elect to reduce the number of brokers they deal with, as well as potentially paying each broker less. Smaller brokers with a strong research product are negotiating good payments for access to research as well as access to analysts. In contrast, some larger brokers with a good waterfront product seem more focused on signing up a wide coverage list with a relatively low price, but charging more for analyst access. For the middle ground, striking the right price is proving difficult: too high a price risks being priced out of the game, while too low price may not be sustainable.

This more competitive research environment is seeing new models emerging for evaluating research. While many firms will ask portfolio managers to rate research, others may complement this with a more automated approach. TIM is now working with its partners to evaluate analyst research for its predictive accuracy. If a buy-side portfolio manager is looking for a good analyst, why not find out how well that analyst’s predictions have worked out in the past?

Trade ideas status quo

Trade ideas are the primary service that sales teams provide to clients that can add immediate value to the client’s investment process. As research budgets come under increasing scrutiny, trade ideas programs are largely untouched because most trade ideas programs pay brokers directly and independently of trading, in a manner directly related to their contribution to fund performance. Quant funds are some of the largest consumers of trade ideas and their pay-for-performance models embody much of the spirit of unbundling without change. Some of the largest fundamental firms worldwide have also adopted the pay-for-performance model for trade ideas, with one of our clients allocating best rewards to contributors that outperform his own fund.