Numerous fund houses have been taking on the cost of research – in large part owing to the Mifid II regulations, coming into effect next year.
Many in the industry agree with the legislation to provide transparency on research fees where it holds fund managers accountable for what they charge to clients.
The new rules from the FCA implementing Mifid II on research are part of the overall aim to improve the transparency of the fees that managers are charging clients.
The new regulations willlet investors see any charges they pay for externally generated research used by their fund managers. However, charging fees for research is not necessarily a bad thing.
Under the old regime,the distinction between trading commissions and research fees was opaque,and the link between the value of research provided relative to amounts paid in fees was largely undefined.
The FCA wanted to increase the accountabilityof the fund manager in justifying the amount paidfor research by investors.
- New rules on research are part of an aim to improve transparency of the fees managers are charging.
- The biggest losers are expected to be sell-side research providers.
- Research might become a loss-leader for the big banks to retain client relationships.
Under the new regime, fund managers will still be able to use investors’ funds for research, but they must have a pre-defined budget for the costs they expect to incur and, more importantly, disclose this to clients.
Many of the large fund houses, which have historically always charged their clients for research, have now taken the decision to absorb these costs themselves. These are the likely reasons:
- Absorbing the costs of research for a large established fund house is not overly onerous.
- Absorbing research costs is preferable to the burden of going through the exercise of disclosing and then justifying such costs to clients.
- Taking the decision to absorb costs can also be used as a marketing gimmick to drive fund inflows.
- The FCA’s overriding objective is to drive down fees paid by investors; that is, it implicitly wants fund managers to cover these costs themselves.
The biggest losers are sell-side research providers and fund managers overly reliant on sell-side research.
Typically, the sell-side research providers aimed to generate business for their trading desks, where the banks make most of their money. This meant,in theory, that if a fund manager used a large amount of research from one provider, they would direct more of their trading activity towards that bank, which would then get paid for the research via trading commissions.
Fund managers were obliged to have a system to track such allocations of trading activity, relative to research provided, but:
- The relationship was not clearly defined.
- The amount paid for research depended entirely on the size of the trades, not an independent assessment of the value of the research.
- Fund managers are human and will have biases towards using certain favoured brokers, regardless of the quality of the bank’s research.
In other words, banks that produced research of relatively poor quality could still get paid similar amounts for that research, if the fund manager had a bias to their bank’s trading desk. In addition, trading desks without strong client relationships could still receive orders if the fund manager had received some of the bank’s research and loosely fulfilled their obligation to direct some trading activity to them.
Now that there is a clear distinction between trading commissions and research fees, an obvious path ahead emerges.
Stage one: research costs
This could be a race to the bottom to maintain clients.
Big banks will be very keen to retain and maximise key client relationships to ensure they still receive high levels of trading activity.
Although research will no longer be compensated for via trading, if a client regularly uses a bank’s research and speaks with its analysts and sales team, they will be more likely to maintain their level of trading activity.