MIFID II – research funding “Distinguishing between “standard” research and “specific” research”
Jean-Marie Catala explains the challenges and consequences of the reform of research funding under MIFID II -which took effect on 3 January - and the choices made by Groupama Asset Management in this field.
In practical terms, how would you now characterize the regulatory framework of research finance under MIFID II ?
The main aim of reforming the way that research is funded is to provide greater transparency to the costs that asset managers charge their client investors and so, ultimately, to reduce the risks of conflicts of interest.
So, the Directive requires that asset management companies and investment service providers supply information concerning not only the research spending necessary for managing their portfolios and considered to result in value to the client, but also the method chosen to fund this research, together with the related costs. The fundamental principle is that only the portfolios that actually benefit from research should be required to pay for it. For example, the cost of “small and mid-cap” research will not now be chargeable to a “large cap” portfolio.
The asset management company can pay for the research obtained from its providers and brokers either by funding it directly or by billing its client via an account specifically dedicated to research, the RPA (Research Payment Account).
“Whole sectors of highly specialized research could be abandoned by brokers”
So, MIFID II forces a rethink of the entire nature of research ?
Yes, absolutely. Asset managers must now draw up an inventory of the different asset classes that they manage, in order to arrive at a homogeneous definition of their actual research requirements and then identify the appropriate research providers. This will lead asset managers to be more selective in their choice of brokers and to make sure that the research proposed by these brokers is always well-adapted to the management style over the course of time.
In the case of “equity research”, the cost structure remains quite simple. Up to now, research has been paid via “commission sharing agreements”. MIFID II does not necessarily introduce any major change here, except that the asset manager must now separate the costs of research and execution services and inform the client of these individualized costs, in the interests of greater transparency.
By contrast, the situation will be more complex for fixed income products or for assets considered as atypical, where the “absence of execution costs” has meant that the model just described could not be applied. So, the research for these asset classes could have appeared to be free of charge, because it was not invoiced. So, billing the research in these segments poses a double problem of how to price the research and how exactly to obtain payment for it. The market is moving towards the principle of fixed pricing.
Also, the increased competition that MIFID II is expected to introduce between brokers may result in price-cutting. Consequently, some brokers will be forced to take the decision to abandon whole sectors of research judged difficult to monetize in significant volumes, because they are highly specialized. Also, the Directive is expected to trigger a restructuring of the brokerage universe, with the disappearance or possible regrouping of smaller players.
Can “over-consumption” of research by an asset manager generate excessive costs for the client?
The regulator obliges asset management companies to predefine their research budget per investment strategy ex ante. So, the client investor will be informed of the research budget for 2018, as specifically applicable to the client, and all spending on this budget by the management team in the performance of its mandate will be subject to rigorous monitoring: the client will have to be notified of any over-budget spending, and, if the client refuses, this spending must be paid for by the management company. From this point of view, variations in management style and in the quantity of assets under management in a portfolio can cause significant variations in the research requirements, especially during the investment phase at the start of the management mandate.
“A new culture in handling research”
Does this also imply a major change for portfolio managers in how they use research ?
Yes, it’s true that, for asset managers, the obligation to precisely map the entire spectrum of their research requirements will mean an entirely new culture. Up to now, with no formal classification of research costs, management teams had permanent, constraint-free and virtually unlimited access to large volumes of research that could to an extent be perceived to be free of charge. Under these conditions, the question of categorizing research according to asset class, management style or instrument type was not a priority.
Today, the big challenge is to separate what belongs to “standard” research, which concerns the asset classes benefiting from an industrial approach to investment analysis, from what belongs to “specific” research, which concerns the less conventional asset classes. We also have to identify the players that offer the highest added value in their research work.
Which funding approach will you be adopting at Groupama AM ?
We plan to use two funding methods, depending on the specific features of each management mandate or strategy: standard research will be funded by the asset management company, while specialized research will be billed to the portfolios that actually benefit from the research (as was already the case, in particular, for equity mandates), in compliance with the requirements of the Directive. So, in 2018, we will be applying the same rules of allocation of the costs of specific research, based on the costs that we identified during 2017. We are therefore providing continuity in both quality and cost of service.
We are extremely attentive to this notion of specific research, which especially concerns the asset classes that generate the greatest alpha – meaning, in our case, our funds in mid-caps, convertibles, high-yield and financial subordinated debt. Clearly and comprehensively informing our investors is the key to ensuring a good understanding of costs, in correlation with the generated added value. And, for Groupama AM, as for all our peers, the legitimacy of our research costs is more robustly demonstrable when our management consistently performs well, year after year !
Will MIFID II cause you to adjust your research capacities?
That’s a strategic question. A redistribution between internal research and external research is becoming inevitable. At Groupama AM, we are convinced that in this new environment the specific contribution of our internal research teams must make even more of a difference than before.
Even without other structural adjustments, we are, for example, revising our approach to the Response For Proposal to which we respond, in order to better anticipate the needs for specific research.
For the asset management industry as a whole, the reform of research funding will have an impact on the organization of fund management and on relations with brokers or report providers. This in turn will affect all the resources concerned, in terms of processes, infrastructure, time and human resources.