Evolving face of institutional equity business

A interesting Bloomberg article titled “Wall Street Cracks Down on Free Sharing of Analysts’ Notes” has crossed our desk last week ignited a discussion within our team about the the market for investment research.
The article points out how brokers, to some extent driven by regulatory pressures, are overhauling the process of producing and distributing of research and using online portals to track what gets read and by who- and bringing closer to be able to finally see how much investors are willing to pay for analyst report.
As a refresher, most of equity commissions paid by investors to brokers are split into two components: Execution and Non-Execution. Execution component pays for physical cost of trading and cleaning the transaction, and non-execution pays for other services such as investment research and corporate access. In a bundled commission environment, those two components are not separated and captured by the broker executing the equity trade.
CSAs (introduced in 2007) enabled fund managers to separating commissions into payment for executing trades from payment for research, however most argue they were not not sufficient to determine the value of services consumed, nor control spending. Furthermore the commissions (whether bundled or unbundled) actually belong to the asset manager’s end client however the asset manager has the full discretion of how to spend it.
The direction of regulatory travel is towards complete unbundling, something that we believe , will reshape the economics of institutional equity business, carrying with it serious implications to asset managers, sell side firms and IR teams.

We see those five questions are at the crux of the debate:

1- What has been happening to global trading commissions, which still drive the vast majority of supply of research and corporate access services?
Post crisis environment brought about the worst bear market for equities since the 1930s. Combination of depressed equity valuation, lower trading volumes, lowers fees generated from IPOs and primary market activity, a steady shift from active to passive investing meant a significant decline in available commissions for equity businesses providing research and corporate access. The effect was particularly severe outside North America where commissions are calculated as a percentage of the value of the share price. Emerging markets as a whole have also suffered their own set of dynamics which have further reduced comission dollars and meant instances of banks shutting down entire operations (ex. DB in Russia, CLSA in , Nomura in)
So what did this mean for broker revenues? Frost Consulting estimates that there has been a 43% reduction in global commissions for equity research, leading to a 40% reduction in budgets allocated by the 600 or so reduction in budgets allocated by the c 600 firms producing equity research from US$8.2bn at the peak in 2008 to US$4.8bn in 2013.

2- What would regulators like to see commission payments used for?
In short, just for execution. The UK’s Financial Conduct Authority wants brokers’ research to be treated as a cost to the manager and paid out of their own P&L rather than paid for out of client funds- a reform known as “unbundling”. This may eventually lead to a “priced” market for investment bank research which could transform the market in which consumers (investors) only receive the products they want and purchase in which personalisation, interactivity, niche focus will be critical for commercial success. The changes could provide an advantage for independent and specialist firms. In 2014, the FCA already banned using client commission payments for Corporate ACcess in the UK in 2014, a rule that is still looks that is yet to be adopted flouted

3- Are investors treating commission spending as if they were their your own?
Milton Friedman, the US economist, once said that perhaps the most wasteful form of spending is spending someone else’s money on somebody else: you are then “not concerned about how much it is, and not concerned about what you get get”. Perhaps there is a little bit of thoughts that can be applied to current discourse in the asset management industry. Regulators feel that allocation of spending (and hence the pricing) of broker services would have been different if investors had to pay for it from their own pockets. Surely, they argue, more considration would go into what is valueable, hence

In last year’s survey by the CFA Society UK, almost half of respondents think that Investment firms in the UK do not manage dealing commission – which is a client asset – as carefully as if it were their own money.

payments as if it were your own?

5- What do investors value most from brokers and how is that value priced?
Investors consume a number of services from brokers, and

Experts say that one of the trickiest aspects of pricing research is working out its value.

Reverse roadshow / investment trip to
Face to face management meeting at home
An Investor Conference
Call with reserach analyst
A report

Related articles
Bloomberg: Ballad of a Wall Street Research Analyst, Told by Brad Hintz

Equity Research Worth Paying For : A Look at Economic, Digital and Regulatory Changes

This is a guest summary post by Alphametry CEO Fabrice Bouland, of a recent senior executive roundtable about the future of equity research. You can download the full whitepaper version here.

An industry in trouble?

  • Global investment banks have seen shrinking revenues and in turn have been allocating increasingly smaller budgets to equity research. Several external factors affect revenues, among them:
  • Lower trading volumes caused by post-financial crisis industry deleveraging;
  • Fierce competition from electronic trading automation;
  • The rise of passive investing with exchange-traded funds (ETF) products rather than direct equity ownership;

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  • At the same time, supply issues such as mid and small-cap stocks poorly covered are adding a layer of complexity to the agenda.
  • The market as a whole is also very opaque in terms of pricing and service levels.
  • The delivery of content is about to radically change. The bulge bracket investment banks are starting to move towards digitization.

SAVING EQUITY RESEARCH

  • Regulators are pushing for research spending transparency on several key areas, including:
  • Price disclosure;
  • Approved budget and reporting;
  • Forecasts of how much research to spend; and
  • Assessment of investment value versus spending.
  • Since its introduction in 2007, the use of commission sharing agreements or CSAs has gradually expanded as a tool of choice for asset managers to access independent research.
  • On the regulator’s side, it is UK’s Financial Conduct Authority (FCA) that is taking the lead on the unbundling efforts while others, like the French Authorities AMF continue its support of CSAs, only advocating to add more transparency measures.

” There is strong evidence to suggest the current model of using dealing commission to pay for research reduces transparency and creates a link between research spend and trading volume, without a clear assessment of the value this offers to investors”  – Martin Wheatley, Former CEO of the FCA, who stepped down July 2015

  • To replace CSAs, the FCA wants to implement the new Research Payment Account (RPA) scheme and will ban inducements.

THE PRICE OF EQUITY RESEARCH

  • Separating research from execution raises a simple question that will be exceedingly hard to answer: how much is research worth? In a survey from a Bloomberg Institutional Equities Event, respondents were asked what factors were the biggest challenges when valuing equity research:
  • 37% said transparency was the biggest challenge;
  • 25% said ‘a la carte’ pricing;
  • 21% pointed to pricing benchmarks;
  • 10% said disparate evaluation; and
  • 7% said regulatory clarity.
  • Pricing equity research was a hot topic in the Alphametry roundtable. Participants noted that as there have never been internal benchmarks for evaluating equity research and that the range of pricing will probably be very wide.
  • Are current investment research prices fair? Sentiments from the sell-side in the roundtable leaned towards a “name your price” approach. Some participants were interested in exploring commission-based models with various level of service.

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  • Similar sectors like digital news media are changing their entire business models because content that was once paid is now free.
  • Another factor that plays into pricing is content longevity or shelf life. Roundtable participants pointed out that some content such as sector reports could be relevant for months.

INVESTMENT RESEARCH 3.0: AN INDUSTRY REBORN

  • Regulation is converging and investment firms are building global compliance platforms applying best local practices.
  • Research is going through its digital transition phase. As more content becomes digital, the industry is focusing less on the velocity of data and more on how large datasets can be analyzed.
  • Data volume is rising exponentially. Social data, web site usage, physical surveillance (e.g. shopping center parking spaces), and connected object will all be taken into account.
  • The industry is facing its largest organizational restructuring challenge ever in building up staff experience on the technology stack and using analytics to understand clients better.
  • Distribution platforms are playing larger roles and platforms that can deliver fully digital content with integration and interactivity have the upper hand.
  • All information-intensive industries such the media will be re-intermediated.

PARTICIPANTS

BNP Paribas, Citigroup Global Markets Asia, CIMB Securities, CLSA, Deutsche Bank EFA, Global Equity Flow, IBT, Morningstar Asia, Nomura International, Société Générale, Shenwan Hongyuan Research, UBS

To gain deeper insights of equity research digital trends and emerging economic models, download here your free copy of Alphametry roundtable whitepaper.

Research Regulations: the Quest for Clarity

More than 200 investment professionals gathered last month at the Institute of Directors (IoD) in London for a series of panel discussions on investment research, and how it should be provided and paid for. With corporate access now formally ‘unbundled’ from trading execution services in the UK (meaning fund managers must pay brokers to organise meetings with company management separately and out of their own pockets), the focus has shifted to research, which the FCA decided not to touch the first time around.

CSAs (commission sharing agreements) already exist to keep fees for execution separate from fees for other services such as research and corporate access, although the precise value of each remains somewhat unclear. Now faced with the prospect of potentially having to pay for all research themselves, rather than passing the cost on to their end clients, fund managers (and regulators) are taking more of an interest than ever in its cost and value.

At the IoD there appeared to be broad (although not unanimous) consensus that ‘something needs to be done’ to resolve the cost/value question, although there was some difference of opinion on exactly what and how.

What is wrong with the current research model?

Regulatory scrutiny is centring on:

  • the use of research as an ‘inducement’ (so investors will execute trades with the broker publishing the report)
  • the fact that the current model discourages competition
  • the lack of transparency around both cost and benefit

The FCA’s main goal is to ensure a fairer, more competitive, more efficient market. The key to this is transparency. CSAs were introduced to bring greater clarity to the whole commission payment structure, although the feeling is that they actually tend to muddy the waters, encouraging brokers to juggle commission between services to ‘reverse engineer’ fees.

Thus one of the regulators’ top priorities is to cut the strings that are attached to ‘free’ research and encourage greater competition for individual sell-side services.

How much should investors pay for research?

On the face of it, imposing arbitrary prices on research reports would seem to make little sense and in any case is almost certainly beyond the remit of regulators. The popular view seems to be to let the market decide.

Most investors agree that the aim of regulation in this case should be deregulation: once you remove all barriers to transparency and competition, the free market will determine the price through simple supply and demand economics.

In most cases it is still the end users who are paying for research and other services (through trading commissions), although making fund managers cover these expenses out of their own pockets should help to close the gap between price and value and stem the tide of ubiquitous ‘free’ research.

How is research currently consumed?

The vast majority of institutional investors undertake a quarterly voting process to evaluate and rank the quality of the sell-side research offered by the various providers. Once rankings are determined, budget is allocated accordingly (different services carry different weights).

Investors also rely to a varying extent on their own research and more often than not, on the sea of reports which are available either from one of the major data providers or through analyst connections. Many supplement ‘bundled’ sell-side research with reports from trusted, independent providers. When the budget is spent, they go ‘execution-only’.

The potential rule changes are forcing investors to think long and hard about what they actually need and whether the research they currently consume is worth what they might have to pay for it. As a result, fund managers are being encouraged by their firms to use whatever tools are at their disposal to more closely monitor consumption and assess value.

In recent years there has also been a growing tendency for buy-side firms to bolster their own in-house research capabilities, thereby reducing their reliance on potentially expensive sell-side services. This of course requires time, money and expertise, but the potential benefit for individual firms in cultivating their own proprietary investment ‘edge’ is obvious.

How would rule changes affect the market?

Opinion seems to be divided on how potential changes would affect the market. Below are some of the main advantages and disadvantages to unbundling research raised at the conference:

Potential advantages

  • Execution services would move more freely
  • Research would become more specialised
  • Independent research firms would benefit from a level playing field (one attendee suggested consumption may triple from its current level of 8% per firm)
  • Similarly, sell-side firms who produce research reports in markets where they do not execute trades (e.g. Standard Chartered in Russia) would not be unfairly excluded
  • A growing culture of in-house buy-side research would help to differentiate firms

Potential disadvantages

  • There may be a reduction in the depth and breadth of sell-side research
  • Small- and mid-size firms may be excluded from sell-side research distribution
  • Boutique sell-side firms may lose out

These discussions are likely to continue until the respective regulatory bodies can provide some clear guidelines on rule changes and timescales. Many at the IoD expressed growing frustration that, having taken the lead on this issue, the FCA seems now to have backed away; the recently announced delay of MiFID II has also left a number of important questions unanswered.

Some are putting their faith in the market to resolve these questions, the idea being that if a large minority of asset managers lead the way then the rest of the market will follow. There are already signs that this process is underway, with a number of firms reaching into their own pockets to cover not only corporate access, but also research. One of the more interesting quotes of the day came from a fund manager who said “If there is a distribution platform that works, research will unbundle itself”. Healthy markets have always been founded on efficiency.

The need for change is apparent, and now finally it seems the appetite is too. Hopefully 2016 will bring a new sense of purpose and clarity to an issue which continues to create uncertainty for investors, brokers and companies alike.

What does this mean for company IR teams?

Should the regulators decide to fully unbundle research, there would likely be a decrease in the amount of sell-side reports written and distributed, particularly on non-blue chip companies, as analysts begin to take a more focused, tailored approach. Investors would be forced to rely more on their own in-house capabilities and on information directly from the company. In both cases the role of investor relations takes on extra importance as fund managers are less willing to invest their own money in the expertise of brokers.

The likely growth in buy-side consumption of independent research would present an increasingly attractive option to companies looking to reach a wider audience of investors. There would be an opportunity for technology start-ups to follow in the footsteps of companies like Stockviews and SeekingAlpha to fill the gap left by free, ubiquitous, one-size-fits-all sell-side research.

As discussed above, regulatory changes are still some way off, so the best thing IR teams can do at this stage is to stay on top of developments and maintain best practice IR, strengthening connections with both sell-side and buy-side.

Unbundling: 4 questions to consider

As UK’s FCA and European regulators continue to clarify their stance on commission ‘unbundling’ we thought it might be useful to quickly revisit the debate and attempt to answer a few questions at the core of the debate.

To recap (also see our earlier piece: Brief history of the dealing commission), most equity commissions paid by investors to brokers are split into two components: execution and non-execution. The execution component pays for the physical cost of trading and clearing a transaction; the non-execution component pays for other services such as investment research and corporate access.

Commission sharing arrangements (CSAs) enable fund managers to keep the two components separate, however until recently they have tended to be ‘bundled’ together into one commission payment. CSAs have been criticised for their lack of transparency in helping fund managers to determine the value of the services consumed and to control spending. Furthermore, even though the fund manager has full discretion in how the commission is spent, it is paid for by the fund manager’s end clients.

In Europe at least, we seem to be heading towards complete unbundling, which will likely have profound implications for asset managers, sell side firms, IR teams and entrepreneurs alike

1. How have global trading conditions affected made the supply of research and corporate access services?

The post-credit environment has ushered in the most difficult period for equities since the 1930s. This is due to a huge combination of factors: depressed equity valuation, lower trading volumes, lower fees generated from IPOs and primary market activity, equity market fragmentation and HFT, and a steady shift from active to passive investing. All of this has contributed to a significant decline in available commissions for equity businesses providing research and corporate access. Emerging markets have fallen prey to additional dynamics, which have further reduced commission dollars from trading and caused banks to scale back their securities operations and in some cases shut down entirely.

So what does all of this mean for broker revenues? Frost Consulting estimates there has been a 43% reduction in global commissions for equity research, which in turn has led to a 40% reduction in budgets allocated by the 600 or so firms producing equity research, from $8.2bn at their peak in 2008 to $4.8bn in 2013.

2. What would regulators like to see commission payments used for?

The UK Financial Conduct Authority (FCA) wants broker research to be treated as a cost to fund managers to be paid out of their own P&L rather than out of clients’ funds (‘unbundling’). This may eventually lead to a ‘priced’ market for investment research in which consumers (investors) only receive the products they are willing to pay for. It seems reasonable to assume that this will lead to greater personalisation, interactivity and niche focus. Such changes could offer independent and specialist firms an edge, as well as present opportunities to the long tail of companies often overlooked by sell-side analysts. In 2014 the FCA banned the use of client commission payments for corporate access in the UK, a rule which made waves in the investment community but has yet to be fully adopted or implemented.

3. Are investors paying commission responsibly?

Milton Friedman, the US economist, said that perhaps the most reckless form of spending is that which involves someone else’s money as you are “not concerned about how much it is, and not concerned about what you get”. Perhaps this thinking can be applied to commissions. Regulators feel that the amount of money allocated to (and by extension the pricing of) broker services would be somewhat different if investors had to pay for it out of their own pockets, and that more thought would go into the true value of these services. In last year’s survey by the UK CFA society, almost half of respondents agreed that investment firms in the UK do not spend their clients’ commissions as carefully as if they were their own money.

4. How do investors assess and quantify value?

Despite the ubiquity of research and corporate access services, there is no uniform pricing model and industry experts agree that it’s a tricky subject. As Matt Levine points out in his column, one of the main challenges is that equity research, at least from a regulatory point of view, is classified as material, non-public information. As such, institutions have a responsibility to distribute it ‘fairly’. Something will have to give.

Many would argue that while these services provide a broad benefit and ultimately make markets more efficient (by helping to disseminate information and underlying analysis more widely), the model only benefits a narrow segment of the market. Asset managers are investing more and more in their own in-house research teams, and in some cases in dedicated corporate access desks. Numerous independent research providers and start-ups have also entered the market to fill the gaps and propose new models. Many of them, like us, believe that technology can play a complementary role and perhaps solve one or two issues along the way.