Research models still open issue
The changes that the UK’s regulatory body the Financial Services Authority (FSA) proposed in its CP176 (abolition of soft dollar payments and the unbundling of research and execution services) have been seen as heralding a major change in the way fund managers and the investment banks carry out their businesses. They are paralleled by changes being considered by the SEC in the US, and if adopted are likely to be mirrored globally.
The prospect of fund managers having to carry the cost of research services on their profit and loss account has been widely debated, and in many cases described as leading to some form of financial services Armaggedon. Other commentators have viewed them as a vital means of cleansing the industry from inefficient and self-serving practices that have been damaging investor returns.
In its follow up policy statement, published on 7 May, the FSA has given the industry until the end of the year to demonstrate clear movement towards full transparency of commission payments for research, execution and third-party services. Despite being a full year on from the publication of CP176, no rule changes have been proposed, although they have certainly not been ruled out. Some industry participants have described this as a victory for their lobbying skills, seeing it as a climbdown by the FSA (a view strenuously denied by John Tiner, chairman of the FSA).
A considered evaluation of the likely impacts of transparency leads to the conclusion that we still do face a radical transformation in the financial services industry. The Deloitte’s study published by the FSA illustrates a wide range of opinions on the likely shape of the market resulting from the proposed changes, but there is still widespread concern that the proposals will lead to dramatic and unpredictable changes in the industry. However far from leading to Armageddon, the route now being followed by the FSA should generate evolutionary changes which will offer the opportunity for fund management firms to re-assert their position as the heart of the industry.
There are already signs that the industry, while not actively embracing radical changes is beginning to accept their inevitability. Richard Saunders, chief executive of the IMA, recently repeated that the IMA’s primary concern with CP176 was not a fundamental disagreement with unbundling. The IMA was much more concerned by the FSA’s attempt to impose a particular business model on the industry. The FSA is now allowing the industry to develop its own range of solutions to the underlying business issues. History shows us that adaptive, competing solutions typically produce more workable and optimal outcomes than monolithic imposed approaches. This is especially true in markets where information flow is limited and, as is argued below, the relationship between the sell-side and buy-side is dogged by poor information flows. Information about the securities markets is abundant, even excessive. Information about the market for sell-side services itself is weak.
The industry changing nature of the transparency proposals stems from the collision of two trends affecting fund managers. The first relates to their use of information.
Information is the heart of the institutional investment industry. Thirty or more years ago, an investment manager’s ability to add value was determined by his access to information that was not already appropriately interpreted by the market. Who and what you knew enabled you to identify opportunities to outperform the markets.
As we moved into the data processing age, the value inherent in ‘randomly’ gathered nuggets of information began to be swamped by the ability of technically savvy asset managers to manipulate increasing volumes of structured data gathered, cleansed and delivered by the information vendors. Competitive pressures then ensured that analysing data sets was not enough. Valuable market information could only be extracted by integrating multiple sources of structured data, so helping market professionals to identify ever more obscure anomalies and areas of opportunity.
However in recent years the ever growing ability of the market to generate data, opinions and ideas threatens to overwhelm our ability to control, filter and process this flood. We add to this the always present assumption that data is never neutral, that it will always be distorted by some element of self-serving bias. We then arrive at the current position in which asset managers feel almost as if they are disadvantaged by their data flow. They receive too much information and have great trouble in transforming it into investment intelligence.
The second trend is the change in the relationship between the sell-side of the industry and the buy-side, the asset managers. Fund managers have moved from seeing sell-side analysts as their primary source of information to seeing them as valued contributors to the investment process, but clearly as a secondary input to the investment decision. However, because of the lack of a transparent payment mechanism for research fund managers have not been able to convert this change in the priority of information provision into greater control over their research costs.
The lack of a payment mechanism also means that the sell-side has for years operated without a detailed and certain understanding of the buy-side’s needs. The buy-side, meanwhile, has bought research without correlating its price to its inherent value – or without a true understanding of its price at all.
Detailed transparency requirements will allow the CEOs of fund management companies to focus on the true costs of all elements of the research mix (in-house, sell-side and independent) and to ensure the correct balance is struck between costs and the value provided into the investment process.
The sell-side is likely have to continue to trim down in aggregate in response to this, further decreasing the amount of maintenance research produced. Sell-side analysts will be required to focus even more strongly on high value-added, ideas stimulating research. This increased focus, together with a push to price research for monitoring purposes, will help eliminate information overload and drive up the perceived quality of the sell-side research service.
Once an appropriate price for research and for execution services is agreed in the industry, the pace of structural change is likely to accelerate. Many different scenarios can be envisaged. Some see the investment banks diminishing over time as research becomes dominated by boutique providers and execution switches to direct access and crossing networks. Enhanced execution services backed by a commercial banks balance sheet would of course remain. Others see the investment banks developing and broadening their range of services in order to enhance the value they add into the process. The purchase of Barra by MSCI, majority owned by Morgan Stanley, may be an example of this development
No one can predict the final outcome in this radical re-shaping of the financial services industry. Participants will try out a range of different business models in their attempts to gain an edge. However we can predict two things. Firstly there is a strong chance that the outcome will be evolutionary rather than revolutionary. Following the intensive lobbying over recent months, regulators around the world are now very aware of the dangers of forcing change too quickly, especially on an industry that is already shaken by a cyclically generated fall in profitability.
Secondly, and more importantly, there is a good chance that these changes will help asset management companies to regain control of their businesses. Commission transparency and the consequent improvement in ability to choose the appropriate research and execution mix should drive a step change in buy-side efficiency and a new era in competition to service their needs effectively. Ultimately transparency of commission flows requires the asset management industry to take responsibility for all of its costs and to take credit for all its achievements. This is an outcome that all sides of the industry can applaud, no matter what the short-term disruption.
Glenn Bedwin is director of business development at Thomson Financial in London