The Markets in Financial Instruments Directive, more commonly known as MiFID II, was introduced in January and brought widespread changes for the finance industry. The new laws require fund managers to pay directly and explicitly for research, instead of receiving it free of charge from brokers and investment banks, except in the case that the firm can prove that the research passes the quality enhancement test.
Sell side businesses must provide their clients with detailed, unbundled costs of services, separating execution, research and advisory services into separate costs. They must also make sure that they can’t be accused of inducing clients by providing research at a rate below the actual cost of production.
Buy side firms must make dedicated payments for research and be able to demonstrate the value of that research in helping investors to make better decisions. They must also have a budget for research and be able to demonstrate that all spending is commensurate with the quality of the research received.
How much will research now cost firms?
Almost all big investment houses decided to shoulder the cost of research rather than pass it on to clients:
- Quoted figures from firms including Janus Henderson, Man Group and Jupiter range from $8-19 million.
- A CFA Institute members’ survey in November 2017 showed respondent firms were projecting a median expenditure of 10 basis points of assets under management for research annually. This is equivalent to $1m costs sustained for every $1bn of assets under management. However, early estimates put the outlay at less than a tenth of this amount.
- A more wide-ranging projection was cited by Moody’s, who put the cost of complying with MiFID II as 0.5-5 percent increase on the current spend by fund managers.
Interestingly, where the cost of research was passed on to clients, spend is far greater than where firms choose to absorb the cost. Data from Frost Consulting based on an analysis of 3,000 funds and 350 asset managers revealed that those firms passing on costs are spending anywhere between 2.7 and 7.5 times as much as their counterparts who are absorbing the costs themselves.
What does this mean for the market?
- Larger firms will lean more heavily on in-house research teams and anticipate the impact of the costs to be less than smaller firms.
- Smaller firms don’t have the same resources and so may be tempted to use less research than bigger firms.
- Firms investing in emerging markets and passing the costs on to clients are likely to far outspend their counterparts who absorb the cost, to the order of 7.5 times the spend.
What does this mean for due diligence?
Due diligence professionals will now have to assess two new things when considering a fund manager:
- What is the difference in spending between a fund that passes on cost to one that absorbs it? Is this that they are paying more for the same thing (which raises MiFID II compliance issues) or are they investing more heavily in research in order to provide better information to their clients, which would indicate a lower risk profile?
- Has a firm chosen to invest less in research than is prudent, purely because this is now chargeable and as a small firm they cannot stretch to that kind of outlay? This would present an additional risk that would need to be investigated and mitigated, for instance through the proven expertise and track record of the manager in their space.
Read more about MiFID II regulations in our article on investment due diligence procedures.