Over the last two years, Europe’s financial markets have had to cope with a raft of regulatory changes, many of these came about because of the introduction of MiFID II.
The second part of the Markets in Financial Instruments Directive from the European Union, which was aimed at standardising practices across markets and providing greater protections and visibility for investors.
MiFID II was introduced on January 3rd, 2018 having been delayed for a year. The UK regulator the FCA recently published a paper on one aspect of MiFID II namely research unbundling.
Prior to the introduction of MiFID II asset managers would pay for broker research as part of a bundle of services they received from their brokers, without really having to justify or breakdown those costs to their end clients. Under MiFID II the costs of broker research must be unbundled from other broker services such as execution and investment managers must now account for these fees.
A spotlight on research costs
The net effect of these new rules was to cast a spotlight on the cost of research for both the buy-side, that’s asset and fund managers and the sell-side, the brokers and investment banks that produce the research.
Investment managers had to decide were they prepared to pay for research or if not what they could reasonably charge their underlying clients for it, and how to justify those charges in terms of value added by that research. That meant that banks and brokers had to reassess their cost bases and the breadth of the research they produced and how they charged for it.
Initial findings from the FCA
We are now twenty-one months into that process and the FCA findings shed some light on just how things are working out and whether the new regime is benefitting the end investor.
The FCA found that many fund managers now pay for research out of their own budgets rather than passing those costs on to their underlying clients and that as a result, the fund managers have increased their scrutiny of other costs such as execution fees. Suggesting that the industry has become more cost-conscious.
The same has been true for stockbrokers, CFD platforms and spread betting brokers, who have reduced the amount of research available to their clients.
The FCA research found that these changes resulted in savings of £70 million pounds in fees in the first six months of 2018 alone (the period studied by the FCA), among the fund managers it surveyed. Charges that under the previous regime would have been borne by end investors.
The FCA findings showed a reduction in research budgets of between -20 and 30% per annum among the forty investment management firms that they examined when compared to their 2017 research expenditure.
As to the availability of broker research and the depth of coverage, the FCA found that most asset managers are getting the research they need.
The FCA also noted that the pricing of unbundled research is still evolving as fund managers try to attribute and quantify the value it adds to their investment processes. Whilst the banks and brokers are still developing their own models and pricing strategies for that research.
More to come from the FCA and research unbundling
Ultimately the FCA expects costs to end investors to be reduced by as much as £180 million per annum, with up to £1 billion pounds of savings over a five-year period. Those predictions were made in early 2019 and the regulator has not deviated from the with the publication of this latest report.
Overall then the unbundling of research from other fees does seem to be benefitting the end investor, many of whom are no longer bearing those costs. These are early days of course and the FCA survey covered a relatively short period of time at the beginning of the process. The FCA will, however, revisit unbundling over the next 12 to 24 months.
This whole subject is part of a wider debate about the benefits of active versus passive investment management techniques, because if you are just tracking an index return rather than trying to outperform it, then you could argue that the manager doesn’t need any company-specific research at all.