Smaller asset management firms face a steeper decline in profits than their large and medium-sized competitors as most of the industry appears set to absorb research costs under the EU's revised Markets in Financial Instruments Directive, industry experts said.
Under the new regulations, known as MiFID II, asset managers will be required to report their research spending separately from the commissions they pay investment banks or brokers for advice on security trades. Regulators hope this will end the practice of asset managers receiving free investment research from sell-side firms in exchange for trading with them.
Bigger P&L hit for smaller firms
Before MiFID II takes effect Jan. 3, 2018, all asset managers that have operations in Europe must have decided on a research payment strategy, the options being to either incorporate the costs in their profit-and-loss statements or to let clients pay for the research by setting up a research payment account.
If most of the industry decides to pay for research from their own P&L, European asset managers could see an average drop in operating profit of 14%, while in the worst case, they could face a 27% decline, research firm CRISIL said in a study released in early September. Smaller firms are likely to come under the greatest pressure in this scenario as the increased costs would affect their ability to deliver high-quality research, according to industry experts.
"We believe that large asset managers will be better positioned to retain large and diverse sources of research," CRISIL noted.
In an Oct. 2 research note, UBS equity analysts estimated that in the U.K., the median impact on profit margins as a result of MiFID II compliance costs will be nearly 3x bigger for firms with assets under management of below £5 billion than for those with AUM of more than £15 billion. The smaller firms will see a median profit margin impact of 280 basis points compared with some 100 basis points for larger firms, the analysts said.
Matthieu Duncan, CEO of Natixis Asset Management, said at the European Security and Markets Authority's annual conference Oct. 17 that smaller players will not be able to absorb the costs and are likely to try and pass them on to clients, which will put them at a competitive disadvantage.
When speaking to S&P Global Market Intelligence, Christopher Bates, head of the financial regulatory practice at Clifford Chance, argued that one consequence of regulatory challenges is that they "increase barriers to entry and make it harder for smaller participants to compete."
Late shift to P&L
Asset managers have taken a long time to pick their research payment strategy, with 59% of firms still undecided at the end of the summer, according to CRISIL's research. By that time, most of the firms that had chosen a route were leaning toward passing on research costs to their clients. Yet, a major shift toward a P&L approach appeared to have occurred in the middle of September, when U.S. group BlackRock Inc. announced that it would absorb the costs of research and was quickly followed by other heavyweights such as U.K. fund managers Schroders Plc, Janus Henderson Group Plc and Man Group Plc, as well as U.S. groups Union Investment Advisors Inc and Invesco Ltd. The latest firm to announce that it would absorb research costs was Switzerland's GAM Holding AG, which said in its third-quarter earnings release Oct. 19 that it expects costs of "mid-single-digit" millions of Swiss francs.
Regardless of which research payment strategy asset managers choose, they will still likely need a couple of years to assess which research mix provides the best possible returns, according to Eoin Murray, head of the investment office at Hermes Investment Management.
"It's all a new world to us, and the most sensible thing to do is to keep your budget for 2018 pretty much in line with what you had for 2017," he said. "And then, as the year progresses, we will have a much better picture of how much do we need to spend to [provide] good outcomes."
The unbundling of research payments and trading fees will require asset managers to develop a methodology that defines what constitutes research and how the different types of research should be valued. Based on that methodology and their research payment strategy, asset managers will be able to assess the future costs of research.
"The simplest form [of research] is written material, and most providers that we speak to are putting lower value on that," Murray said. "More expensive, however, are analyst interactions, and that applies equally to independent research providers or traditional sell-side investment banks."
Apart from research pricing, another important factor that will affect total cost is whether firms apply the MiFID II rules to their entire portfolio or just Europe-based operations.
"Even among those who have chosen their own P&L there isn't complete uniformity," Murray added. "Some, including Hermes, have agreed to absorb costs for all clients globally ... while a number of other firms are distinguishing between clients inside the EU and outside."
Those that have decided to ring-fence their European business will absorb the costs for research carried out inside the EU but will continue to pass on the costs in all other geographies. "[This] is an interesting strategy and perhaps a little bit more difficult to defend," Murray said.