The economics of research are tricky. — Bloomberg
UNBIASED analysis of publicly traded companies is obviously a good thing. So it’s welcome that recent reform could mark a turning point for Europe’s struggling independent research industry.
The risk is that this is an L-shaped recovery unless there’s more regulatory support.
The economics of research are tricky. Analysis of equities has traditionally been produced by brokers to stimulate trading in stocks and funded through commissions on trades.
A portion of the dealing charge would cover research and sometimes other non-trading services.
The United States is relaxed about this so-called soft-dollar approach. Quite simply, it enables fund managers to buy a lot of research.
But the UK and Europe have long been concerned that the joint payment system incentivises asset managers to shunt orders to brokers on the basis of their research ideas rather than the price quoted for the “buy” or “sell” trade. Bundled commissions also shield research from market forces by occluding its value. The risk is that fund managers’ clients end up overpaying for everything.
Hence in 2018, Europe’s MiFID II regulation required that research should be paid for separately. The well-intentioned reform had terrible side effects.
The big brokers rationally engaged in a price war as they started selling research as a distinct product. Most fund managers decided to pay for this themselves rather than pass the cost through to clients, setting aside correspondingly low budgets. The overall amount spent on research plummeted.
The main casualties were independent research firms who struggled to compete. The big brokers increased their grip on research provision. That’s a problem.
Much research on stocks by investment banks is high quality, and regulation has long since clamped down on analysts pumping stocks for the benefit of their firm’s dealmakers. But the output remains subject to potential conflicts of interest given the institution simultaneously serves investors and corporations.
Analysts face indirect incentives to be less critical than peers working for a pure-play research house.You’re not going to make yourself popular with a “sell” recommendation – your employer risks losing business with the company in question. Hence research notes carry fine-print health warnings.
A report from London-based research boutique The Analyst argues that conflicts explain why the number of “buy” recommendations produced by investment bank research departments is much higher than the number of stocks that actually beat the market.
Stock indices can rise even with a large number of constituents falling or underperforming the average. Shouldn’t there be far more “sell” recommendations?Excessive coverage
Moreover, big investment banks have little economic interest in writing on smaller companies where trading is thin and banking fees are tiny. So there’s excessive coverage of large, liquid stocks and too little on the potential blue chips of tomorrow.
The good news is that this year may mark the nadir for research economics.
Three months ago, the UK Financial Conduct Authority (FCA) began permitting the use of bundled payments once more as a means of paying for research, subject to certain conditions.
The research component of the commission is also portable. The result should be more money being spent on the work of analysts. Europe is working on reform too. All this points to the end of downward pressure on the product. European investment-research spending could rise 3.2% this year, according to a Bloomberg Intelligence study.
Things won’t change quickly. Where arrangements between fund managers and research providers are reset annually, it may not be until 2026 that we see any real benefit.
And much depends on what the big investment houses like Blackrock Inc and Fidelity International do. Where they lead, others follow.
So MiFID II’s harm won’t be repaired as rapidly as it happened. The independent research sector is a cottage industry – and barely even that.
Unlevel playing field
New entrants remain deterred by the unlevel playing field. Big brokers can sell research cheaply because the product has legitimate internal users – from wealth management to the corporate finance department – who can subsidise it.The UK deserves a plaudit for acting to undo MiFID II’s harm.
Regulators can still do more. There’s a helpful FCA rule requiring asset managers to disclose a breakdown of their bundled research spending by category. That could be toughened up to explicitly force asset managers to reveal how much they spend on unconflicted research generally, with a clear definition of what that means.
An underperforming fund manager who spent nothing on independent research would face some awkward conversations with clients.
Independent research sector
Better still, make it a policy goal to have a strong independent research sector and probe the industry’s competitive dynamics. The FCA’s preoccupation so far has been supporting the asset management industry.
Then keep going with the previous government’s other reforms like establishing a platform that could purchase research that might otherwise not be written. This year may be as bad as it gets for independent research. But without more regulatory impetus, the future might not much better. — Bloomberg
Chris Hughes is a Bloomberg Opinion columnist. The views expressed here are the writer’s own.
