The UK regulator's focus on the purchase of broker research has shed some light on a traditionally opaque part of the investment process. But in doing so, discovers Nicholas Pratt, it has also highlighted the challenges that exist in proving the value of research.
In November, the UK’s Financial Services Authority (FSA) said it would look into conflicts of interest in the asset management industry. The regulator followed this up with a “Dear CEO” letter sent to the larger firms operating in the UK requesting they attest to managing any potential conflicts of interest by February 26.
Of particular interest to the FSA has been firms’ purchase of research and trade execution services via their clients’ commissions. Whereas execution services have become more transparent in recent years thanks to regulations such as the Markets in Financial Instruments Directive (MiFID), research remains a murky area. The payment for research is often part of a bundled service that also includes execution, making it hard to see exactly what has been paid for, how it has been provided or what value it has.
This lack of transparency only exacerbates the view of research that some investors and managers hold. For example, do managers negotiate as diligently for research paid for by client commissions as they would if paid for out of their own pocket? Is the area of corporate access (where the manager is able to meet with the management of corporate issuers) another example of the favouritism that sell-side brokers show to the bigger asset managers?
According to Gina Miller, founder of SCM Private, a UK-based manager, there is a fundamental principle involved in the debate over the purchase of brokers’ research. “The clients believe that through the annual management charges, they are paying the fund manager to choose and, therefore, research the best opportunities on their behalf. Why should they have to pay for this twice?”
Instead, says Miller, fund managers should pay for execution-only commissions to brokers and then separately pay out of their own pockets for any research which they value from these brokers, just as they would do for any other service.
Regarding corporate access, if it is valuable to them then they should pay for it. “Let’s not forget that if such services provide extra performance not only does it benefit clients but it benefits the fund managers as they will normally be running larger funds with more money received by the fund managers,” says Miller.
The FSA action is a welcome step, she says. “It shows that the new management at the FSA have a completely different attitude to the fund management excesses completely ignored by Sir Hector Sants [former FSA chief] prior to his departure.”
The FSA’s decision to address the issue of broker research is also welcomed by the European Association of Independent Research Providers. One might think that independents would welcome the regulatory attention placed on their sell-side, bulge-bracket broking counterparts and the potential separation of corporate access from pure research. But, says co-chair Peter Allen, this is not the major issue. “The important thing is to make sure that clients’ commissions are not siphoned off to other areas.”
The UK’s trade association, the Investment Management Association (IMA), has responded to the FSA’s action by publishing a paper designed to help asset managers to be compliant with the FSA’s proposals. The paper recommends that managers look at three elements when assessing the research provided by brokers – clarify the capacity in which a broker is acting (in relation to issuers, for example); review the process around research and corporate access; and continue to drive as much value for customers as possible – that is, demonstrate that you are negotiating just as hard when the research is paid for by the clients’ commission as when it comes out of the managers’ own pockets.
In relation to corporate access, the paper lays out three categories which dictate who pays. The first relates to corporate roadshows organised by brokers but instigated by the issuing corporates, in which scenario the corporate should pay the broker. The second scenario is where a meeting between the issuer and the asset manager is organised by the broker but instigated by the manager, in which case the manager should pay the broker from their own pocket.
The third is where the manager requests certain value-added services such as corporate access as part of the research services provided by the broker on an ongoing basis. Here, payment can come from client commission provided that the manager can prove the service complies with the FSA’s four-point test in the Conduct of Business Sourcebook 11.6.5E 1(d) and can demonstrate the value of the service to investors should they be asked to do so.
This final scenario highlights several challenges facing asset managers, as acknowledged by Guy Sears, director, institutional at the IMA and author of the paper, Use of Dealing Commission: Corporate Access/Research Services.
First, there is the lack of detail provided by the FSA on what constitutes “corporate access” and what does and does not qualify as research. “I think managers hoped that the FSA would be more detailed as to what falls under the heading of corporate access but it chose not to and it is, therefore, up to the managers to demonstrate that any purchased research meets the rules. So what we as the IMA are trying to do is to bridge that gap,” says Sears.
Another challenge is that, in order to meet the FSA’s demands for more transparency, the asset managers need sell-side brokers to change their pricing and provide more detailed invoicing. “We published this paper so that major sell-side brokers have something to respond to and where we can agree on areas that can be changed or where they can tell us we are being unrealistic,” says Sears.
There is also the concern that even the most well-intended regulations can produce unintended consequences. For example, by shining a regulatory light on corporate access, it might lead some brokers to restrict the availability of a service and for managers to reduce the amount they purchase, particularly if there is uncertainty as to the FSA’s rules and defintions.
“Corporate access is a fundamental part of the research process and I am concerned that if the FSA does not pay attention to it, its value could be diluted,” says Ray Tierney, chief executive at agency broker Bloomberg Tradebook and a former head of global equity trading at Morgan Stanley Investment Management.
Tierney supports the idea of unwrapping the way research is provided and suggests separate categories be established for traditional sell-side research providers, independent research providers, pure market data providers and corporate access.
“If the FSA is able to produce clear guidelines on what these categories should be, the industry will be able to move towards standardisation and that might be what is needed to drive efficiency and value in the distribution of these products.”
It may also help to solve the fundamental issue at the heart of the debate around broker research – the difficulty of proving quantitative value from a piece of research. Developments in transparency and technology have helped to make trade execution more quantifiable and have made best execution an established part of the investment process. Can the same be done with research?
“You’d think in today’s environment, with all the technology and analytics capability, it would be possible to separate the value from research in the same way we’ve done with execution,” says Tierney. “If you can bring clarity and transparency to what these guys deliver, they’ll be able to model it properly. Right now, there’s a lot of guessing that goes on.”
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