Neil Scarth is principal at Frost Consulting, which works with asset managers and owners on research valuation and procurement issues. Frost helps managers generate research budgets that reflect their investment processes and align with client return objectives.
How is MiFID II likely to change the way investment research is paid for?
There are three options. One is for discretionary portfolio managers to pay for the research out of their own profit and loss account. The other two use client money. First, the ‘Swedish model’, where an asset manager agrees a specific research charge with each of their clients, which then accrues daily. The charge is withdrawn from each fund and fed into the research payment account (RPA), which pays third-party research providers. The final option is to use an RPA funded by commission sharing agreements.
How important is investment research to discretionary portfolio managers’ ability to do their job effectively?
If there were no external research, asset managers would have to provide coverage of around 20,000 global stocks internally even though they may only own 500 stocks at one time. The cost for each asset manager would be huge.
However, some asset managers have already said they are going to use their own P&L to fund research, while others are looking at using different types of external research. No one is suggesting they will stop using it as it is an important investment function.
What compliance requirements are there under MiFID II if you use client money to buy research?
These payments need to be made from an RPA account, controlled by the asset manager. There may also be some custodial-type arrangements. If you use client money, you will need to have a research budget decided in advance, presented to and approved by asset owners. This budget must pertain to the actual investment product that an asset owner owns, so there is no cross-subsidisation.
This applies to all asset classes. These are significant changes. Timeframes are narrowing for MiFID II – it starts on 3 January 2018. Managers will be required to restructure the way they procure, value and pay for research.
How will the research funding decision affect asset manager profitability and competitive positioning?
A very real outcome for an asset manager is the asset owner rejecting the research. If that were to happen, the profitability of those active equity strategies could fall 30%–60%, with the asset manager being left to pay for the research themselves. It’s not just a regulatory matter. Senior management needs to be involved, otherwise choices made for the convenience of compliance could end up determining the strategic direction of the firm.
How can managers that want to use client money to fund research maximise the probability of asset owners accepting their proposed research budgets?
The key thing is to demonstrate that the research budget directly supports the investment objectives of the product that the asset owner owns. The way asset managers communicate with asset owners will change. They will now have to say: “This is an emerging markets product with a targeted return of 1,000 basis points and the external research proponent will be 12 basis points.”
How will MiFID II measures affect the ability of discretionary portfolio managers to do their job?
They will need to provide much more detail around what research they need, why they need it and to value the research and justify it to asset owners. Historically, managers have not been required to do this.
Where does the debate currently stand?
As MiFID II is a directive, not a regulation, it allows national regulators to interpret the rules. The UK’s FCA has already published an implementation guide, and issued more guidance on 3 March. All European countries must issue their rules for local context by July. Asset managers have gone from debating this to figuring out how to implement it. It has huge implications globally, too. The majority of global firms are going to have to run what looks like MiFID rules globally because they have to treat clients equally and running multiple systems will be administratively very complex.
MiFID II is transforming transparency expectations of European asset owners as well. Many allocate capital globally so they are not going to care whether the asset manager is in Bangalore, Boston or Beijing – they will get used to a certain level of transparency and will demand this of all managers regardless of what the local regulator requires.
What does it mean for the CISI’s fund management members?
They will have to review their research procurement processes and understand whether they are consistent with MiFID II requirements. From my conversations with the FCA, there will be no grace period after 3 January 2018. If you haven’t figured this out, you’d better pretty soon. These initial client research budgets, which are critically important, are coming out some time in the second half of this year. It means firms should have established research valuation methodologies in place by the end of Q2, which is not long from now.
This article was originally published in the Q2 2017 print edition of The Review. The print edition is available to all members who opt in to receive it, except student members. All eligible members who would like to receive future editions in the post should log in to MyCISI, click on My Account/Communications and set their preference to 'Yes'.