Asset Managers and Banks bracing for impact
The Markets in Financial Instruments Directive, popularly known as MiFID is a set of legislatives rolled out in two phases in Europe with the first phase initially launched in 2007. The second phase of this directive was recently rolled out in January 2018. The goal of the latest directives are to instill greater transparency in costs and charges, which will help the investor to choose among a myriad of fund choices.
While the legislation is Europe centric, the implications are more spread out geographically. Tabb Group, a US-based company that produces research on the buy and sell-side estimates that about three-fourth of US fund managers will be exposed to MiFID rules.
The regulation runs in 16,000 paragraphs and has taken the fund management industry gigantic efforts to understand the implications and re-design processes to comply with the directives. While the heart of the regulations is at the right place, it is leading to unintended consequences, such as the introduction of “negative transaction cost”, leaving many investors befuddled. Basically, when the fund manager is able to purchase a security at a lower cost than originally intended, the benefit of the difference is passed on through the transaction costs, which at times can even turn negative.
A key directive of this legislation is the unbundling of research costs from the broking commission that the fund managers pay to investment banks. The implications of this directive will be the key focus of this blog.
The erstwhile structure
Before MiFID II, the compensation arrangement between the fund management industry (also called buy-side) and the investment banking and research (also called sell-side) was very different. The sell-side industryused to provide a vast array of research and analytical support to the buy-side industry at no “specifically” stated cost. The implicit arrangement was that the buy-side would route the trades through the bank’s trading desk and the cost of the research would be embedded in the trading commissions, which ultimately flows from the investor’s pockets.
All of this would change with MiFID II because now the fund management industry has to specify the exact amount it pays for research to the sell-side. At the face of it, it looks like a great step benefitting the investor – more transparency should lead to a wider array of choices, bringing down the cost of research while lifting its quality. However, it has much wider implications for both the buy-side and sell-side.
A key directive of the regulation is to limit the number of trading banks can do in-house through matching deals. In addition, it also places restrictions on the use of dark pools to avoid the 2008 financial crisis like situation. Currently, about a tenth of all trading is done through dark pools. We believe that this a step in the right direction because stock exchanges have better audit trails and control mechanisms than dark pools. However, what this means is that the fund managers will have little choice than to route trade through exchanges which charge much higher fees. Thus, the trading cost for investors looks to be heading north.
This is even truer for the fixed income market, which is less liquid than equities. By forcing the fixed income trading to be routed through exchanges could lead to other participants’ front running the trade, thereby moving the price against the buyer. This was one of the main reasons why dark pools became so popular as they provided discretion.
However, the fund management industry is waking up to the need for finding the best execution for their clients. The erstwhile trading arrangement implied that the fund managers had to rely on the handful of brokers they had arrangements with for executing the trade. This limited choice and led to poor execution as the cost of trade may be lower at a rival broker, with whom the fund manager has no trading arrangement.
Choice of research
Currently there are a large number of sell-side analysts providing a huge swathe of research on a number of industries and companies. With the fund managers now required to pay explicitly for research, two things are likely to happen – a) the overall demand for research will come down and b) the focus on the quality of research will increase. According to estimates, the Investment Managers may shave off between $1.5 bn and $3 bn from spending on research in response to MiFID.
Candriam, a €112 bn European asset manager, has reduced the number of brokers it uses from 100 to 70 following the introduction of MiFID at the start of the year. Similarly, Ostrum Asset Management, the €325bn French asset manager formerly known as Natixis Asset Management, has cut the number of banks and brokerages from which it buys research by 20%.
This means that only the best analysts will survive in the sell-side research space. On the one hand, will be analysts with a deep knowledge of the industry they track and on the other hand will be analysts that track niche industries. These top analysts would be in huge demand, with only the top banks able to afford them. The reduced supply of research, which will eventually adjust to the backward shift in demand, would lead to fewer choices for the fund management industry with respect to research while increasing the cost of sell-side research. Sounds a bit like capitalism of the research industry.
Cost of research
According to a study by the CFA Institute, analyst research is predicted to cost a median of $10 mn for every $10 bn of equity AUM or 0.1%. Thus implying a large bill may be awaiting fund managers once MiFID is rolled out. However, estimates vary hugely with some such as Man Group and Jupiter suggesting 1 bp as cost of research, while the CFA study respondents indicated 5 bp-20 bp in their estimates. Also, respondents expected to spend much less on a fixed income, alternative and quant research.
Some asset managers have been quoted €200,000-€500,000 for full-service packages, which include face-to-face meetings with analysts, while basic access to research platforms costs as little as €10,000 annually. The average research cost for Candriam has been in the €120,000 to €175,000 range. We believe the picture will become clearer in a year or two when the negotiations between the buy and sell-side are settled.
How has the buy-side reacted
With MiFID II requiring the buy-side firms to specify the cost of research, it means that either they pass on such costs to the investors or absorb the same. The former, while desirable, is the least preferred of the two options. The active fund management industry has been disavowed for not being able to generate significant additional return compared to the benchmark, which does not justify the hefty management fees charged on AUM. Due to this, there has been a flight from active to passive management with even some big names in active management taking notice and joining the passive management industry. ETFs have crossed $5 trillion in AUM this year.
Thus the better option is to absorb the cost, which is what most of the fund management industry has chosen to do, including big names such as Vanguard, Aberdeen and Jupiter.
MiFID is an excellent idea, which will take a while to implement with the full implications and complications better understood. The unbundling of research is an investor-friendly initiative albeit a bit late in the day when the active fund management industry is already under pressure to perform amidst strong competition from the passive management industry. We hope that efforts taken by the fund management industry to seek the best execution is able to counter the higher cost related to routing trade through exchanges. We also hope that choice of research is not significantly reduced and that the unbundling of research leads to lower cost for investors overall with a wider choice. Full implications will become clear in 12-18 months once the dust settles.