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Tighter focus on research spending is prompting fundamental change at Investment banks’ research departments to try and hold on to their asset management clients

Global fund managers could see their profitability significantly reduced and operating margins on their key active equity businesses fall by as much as 50% if they had to pay for the $5 billion cost of equity research currently covered by investment banks. This is the key conclusion of a study carried out by specialists Frost Consulting, the leading international authority on global equity commission unbundling and related market /regulatory change, and Quark, one of the world’s top providers of publishing software to businesses and financial institutions.

Such a scenario is now not outside the bounds of possibility. How asset managers pay for equity research is one of the key challenges facing the sector. It has already been examined by regulators in both the UK and the US and will be the subject of a report to be released by the London-based Investment Management Association (IMA) early next month.
Options being considered by regulators, industry bodies and analysts is not allowing client commissions to be used to pay for equity research and requiring clients, such as large pension funds and insurance groups, to pay for equity research themselves or mandating that the asset managers should pay for their own research.

The ties between investment banks equity research teams and asset managers has already been weakened by the rise in recent years of Commission Sharing Agreements (CSAs) and Client Commission Arrangements (CCA) as they are known in the US. Now 90% of large asset managers in the UK use CSAs, 80% in the US and in Europe (ex UK) the figure is 60%. These agreements allow asset managers to separate the commission they allocate for execution from the commission they pay for research giving them the opportunity to take research from a greater array of providers, including independents and reducing the investment banks’ market share.

At the turn of this year, in the UK, the Financial Services Authority, now split into the Financial Conduct Authority and the Prudential Regulatory Authority, wrote to the CEOs of large asset management groups, following a lengthy review, about its conflict of interest concerns over how they run their operations. One of the key problem areas identified by the review included firms failing to adequately control the amount of customer money spent on research and execution services, and a failure to regularly review whether services were eligible to be paid for using customer’s commissions.

If the outcome of the intense scrutiny on how equity research is paid for ultimately resulted in asset managers having to pay for their own research, this would see the $5 billion cost of that research transferred to asset manager’s P&L. In the event of such an outcome, Frost Consulting, basing its research on available information on publicly-listed international asset managers, estimates that the operating margins for their active equity businesses would almost halve from around 23.5% to 12.5%. Active equities can vary from 20% to 100% of an asset manager’s business depending upon the breadth of their multi-asset class offerings (or lack thereof).

Although it’s unlikely that regulators or bodies such as the IMA would recommend such a move, at least in one step, it is likely that they will continue to call for further accountability.  At a minimum, asset managers should have proper budgets to account for any costs related to research and to identify what part of the research they receive should appropriately be covered by client commission.

This shift plus the spread of commission sharing agreements giving fund managers greater options to choose research providers, is prompting the investment banks to finally look at how they run their research departments, focusing on productivity and providing fund managers with the most relevant reports delivered in the most accessible, flexible formats. As the Frost consultants say, in order to succeed in this new era “investment banking research will have to work harder to stand out.”

To address this, investment banks are turning to new digital publishing technologies for a number of reasons. In terms of improving productivity, such publishing formats as HTML5 allows reports to be easily re-formatted and re-purposed throughout the process to improve research teams’ efficiency as well as their clients’ experience. It also allows fund managers to consume their information on whatever device they have with them, whether mobile, ipad, laptop etc.

With regard to improving the relevance of what research departments send to fund managers and how they can improve their client’s experience, the technology offers mechanisms to create and structure content to make it more useful to asset managers. The new platforms allow more interactivity so clients and providers can share and compare views and information, play out and model different scenarios on sectors and stocks with each other. Information, say a word, sentence, paragraph, section or page can also be semantically tagged to make it more easily ‘findable’ by search engines.  Further, the richer meta data describing the research content can be used to help filter research output so clients only receive the reports they have a real interest in reading.

Neil Scarth, Principal, Frost Consultants, comments:

“No question asset managers are under pressure to provide greater transparency and accountability in terms of how they pay for the equity research they receive. The old model of having the research paid for in part by commissions is being eroded and it they were forced to cover the whole cost of the research they use it would have very significant impact on their operating margins and profitability.”

Richard Brandt, Director of Financial Services at Quark, comments:
“It would be absolutely accurate to say that investment bank research departments are operating more like Amazon in an effort to get closer to their clients. It is of course important that clients are aware of this aspect and opt in and accept this. As a research producer, being able to see what your clients are, or are not, reading so you know what they care about is invaluable. With this you can tailor your offering to focus on the research clients value most. It’s more efficient and your clients receive a more tailored service.”