At a time of desultory returns, with performance fees still a distant memory at many funds and plenty languishing below high water marks, the scope to use investors’ money to cover the cost of managing that money is a lively topic of discussion. In fact, putting costs on to the fund is an existential issue at firms struggling to run their business on management fees alone. The use of investors’ money to buy research and execution services from investment banks and brokers is the quintessential issue in this increasingly contentious field.
It is obviously essential to the investment process, since it governs asset allocation and stock selection, but equally commissions belong to the fund and not the manager. It is also an extremely lucrative market, with managers spending an estimated $20 billion a year on research on top of $10 billion for execution. And the way that $20 billion is being spent has come under intense regulatory scrutiny in the United Kingdom over the last five months. By 28 February this year the chief executives of 195 fund management houses in the United Kingdom were obliged to attest personally to the Financial Services Authority (FSA), their local regulator, that they were in compliance with a set of rules on the management of conflicts of interest in the use of commissions set out in an FSA document published in November last year. That document, entitled Conflicts of interest between asset managers and their customers: Identifying and mitigating the risks, effectively obliged the senior management of every fund manager to make sure commissions were being spent on execution and research and nothing else; that they were not being spent in ways that undermined the obligation to achieve best execution; and to disclose to clients exactly how their commission monies were being spent. The document also effectively banned the use of commissions to purchase “corporate access” from investment banks. Lastly, it cited with approval a fund manager which “set a maximum spend on research services and, once these limits were reached, switched commission rates for the brokers concerned to execution-only rates for the remainder of the commission period.” This is actually a much more revolutionary idea than it sounds. It forces fund managers in the United Kingdom to set fixed research and execution budgets for every broker from which they buy services, and take business elsewhere once that budget is exhausted. This measure effectively decouples research expenditure at brokers from transactional activity.
Instead of research expenditure with brokers rising and falling in line with the commissions generated by dealers acting on the instructions of portfolio managers, fund managers will now have to decide what research is worth buying from each brokerage firm they deal with. For the first time, in the United Kingdom at least, research is going to be bought on price alone. Fund managers will buy only the research that they consider worth buying, and will receive only what they agree to purchase. Investment banks will find their research revenues are automatically capped. Research purchases will no longer rise in line with transactional activity.
With the starting price point being set at a relatively low point in the financial cycle, at a time when the volume of equity trades is suppressed by comparison with historic norms, quite a few research analysts at investment banks are going to lose their jobs over the next few years. Inevitably, investment banks will be forced to restrict the distribution of research to those clients willing to pay for it, either by subscription or on a piece-by-piece basis. Such practices may well spread further afield than the United Kingdom. After all, which chief compliance officer will be content to eliminate conflicts of interest in research procurement in the United Kingdom while continuing to live with them in the United States, continental Europe and Asia?
Editor in Chief
12th April 2013