MiFID II’s unbundling requirements are changing the nature of investment research across the globe, not just in Europe. In a preview of TABB Group’s latest research report, founder and research chairman Larry Tabb looks at how unbundling has affected the buy side in the US.
The unbundling of research from execution seems like a natural advancement. Outside of investment research, who invests in highly trained, registered and qualified personnel to create a product that is given away for free – on the hope of possibly getting something in return sometime down the road? Anyone coming to me with that business model would need to have a really good reason why it would work and why they shouldn’t be kicked out of my office.
But that is exactly how investment research has been distributed since time immemorial. That is, until European regulators implemented the Markets in Financial Instruments Directive II (MiFID II) in January 2018.
It’s a year and a half later, and given the transition from bundled research to full unbundling in Europe, it’s a good time to check in with institutional investors to see how unbundling has affected the buy side in the US. According to TABB Group outreach, not only has unbundling impacted US money managers, it is changing the whole nature of investment research.
Increasingly, the large buy-side firms are embracing unbundling, as it enables them to better manage their business. It provides greater clarity around what research managers need, the cost of obtaining that information, and the service models it entails. It also allows buy-side traders to focus their attention on sending their orders to the most effective execution desks, instead of allocating those trades to research brokers based on their investment ideas, even if their trading desks are not truly effective.
While unbundling has helped larger funds, not all firms have embraced it. Mid- and smaller-sized firms with fewer assets under management and less substantial commission wallets now have to pick their providers, negotiate a value for their chosen research, and hope they have a large enough budget to fund their investment strategies. This will hurt smaller investment managers and effectively consolidate the market for active investment services, pushing investors toward passive strategies and concentrating the investment services business into fewer and larger firms.
This challenge can’t be placed solely at the feet of unbundling, of course. Unbundling has, however, complicated the cost of acquiring knowledge and running an actively managed portfolio, making it an interesting time for institutional asset managers who are certainly feeling the pressure of fee compression associated with the active-to-passive transition even as the cost and complexity of buying alpha-generating research further complicates the investment management process.
While the MiFID II changes do not legally impact US institutional asset managers, we are finding that the larger asset management organizations not only want a consistent global research procurement process, but that asset owners want to ensure they are being charged and treated consistently and fairly, whether they are located in Bruges, Boston, Belarus, or Beijing.
While consistency and fairness are important, however, many US investment managers believe that the MiFID II regulations go too far and do not want to see the full MiFID II suite of regulations implemented here.
While a significant proportion (17%) of the asset managers surveyed by TABB Group believe that the greater transparency provided by MiFID II is beneficial, and 14% think the ability to unbundle research from execution commissions is an improvement, the preponderance of comments on MiFID II are negative. Slightly more than 40% say they don’t want to see MiFID II come to US shores, while 17% believe that MiFID II both harms liquidity and benefits larger funds, and 14% say that it adds complexity. In addition, 12% feel that both unbundling and the overly prescriptive reporting requirements are not beneficial, while 11% think that the increased rules associated with MiFID II reduce the agility and flexibility of money managers. (See Exhibit 1, below.)
Of the 126 comments we received from 92 head and senior traders on the desirability of MiFID II being adopted for the US market, 80% can be construed as negative or very negative, while only 20% can be positioned as a positive.
Exhibit 1: The Benefits and Challenges of Bringing MiFID II to the US
Source: TABB Group IET study 2019
The ability to manage institutional money has become more challenging. While there has been a significant pick-up in politically instigated volatility, it remains hard to outperform the increasingly upward market trend over the past decade. As a result, more investors are parking their assets in low-fee, trend-following passive and exchange-traded-fund-driven strategies. While this seemingly should make active management more desirable and increase the opportunity for active managers to differentiate themselves, as index-based investing generally treats competitors alike, it has not. By consolidating the bottom-performing managers, it has increased rather than reduced the difficulty for money managers to beat their benchmarks and has exacerbated the business model concerns of active managers. On top of this challenge, the implementation of MiFID II and the movement toward unbundling of research and execution, which in the long run may not significantly impact active managers, has in the short-term dramatically increased the difficulty of obtaining and paying for investment research.
While we don’t believe that the ability to acquire investment research will be an existential threat to the fund management business, unbundling will dramatically change how investment research is procured, funded, and serviced as it reshapes the character and capabilities not only of the US asset management industry, but of its brokers and service providers as well.
To learn more about the impact of research unbundling on the US financial markets ecosystem, please contact TABB Group for details on our latest research report, “US Institutional Equity Trading 2019 Unbundling: How Charging for Content Is Reshaping Asset Management,” by Campbell Peters, Larry Tabb, and Elyse Gerard.