IS INVESTMENT RESEARCH SUICIDAL?
In June 2014, the UK Financial Conduct Authority dropped a bombshell on the asset management industry's already crowded regulatory landscape. After several months of consultation with industry players, the regulator concluded that all investment research was to be priced and further advised that dealing commissions may no longer be used to pay for research.
Five months of intensive lobbying later, the European Securities & Markets Authority declared they were backing down (for now), advising that ‘substantive research’ may continue to be financed by execution, albeit under stricter conditions.
Is this regulatory upheaval the end of the road for equity research, or a fresh start?
AN UPSIDE-DOWN MODEL
Most financial market professionals can’t really remember why investment research has been free for the last 40 years. The dealing commissions that asset managers pay to their prime brokers gives then in return access to a firehose of macroeconomic, strategy, industry and stock reports. Put less kindly, their e-mail inboxes are usually buckling under the crush of numerous, lengthy reports. Much like the servings at an All-You-Can-Eat american diner, the enormous amount of content produced (mostly by sell-side analysts with strong expertise and unparalleled access to information), goes mostly to waste. There is no time to digest it or quickly find relevant intelligence within the proverbial haystack of PDF files.
This runs counter to most B2B models, which have made a dramatic shift to free network access paid for by value-added services, telecoms being a prime example. Yet valuable equity research content has remained free, while trade execution, a commodity, comes at a price. To make matters worse, execution commissions are declining in volume and value. Thanks to integration and systems automation, execution pipelines costs are continuously dropping.
This relentless downward pressure on the equity research business model leads us to wonder what will happen when execution becomes free.
Because it probably will.
THE PERFECT STORM
Decades of industry oligopoly and entrenched interests have kept this unsustainable model in place. It took considerable tenacity for the FCA (formerly the FSA) to finally introduce some competition in research production through the Commission Sharing Agreement mechanism in 2007. This allowed independent research providers (IRPs) to indirectly collect roughly half of the buy-side dealing commission spending. While it was a breeze of fresh air for investors, looking for alternative analysis from pure players with little or no conflicts of interest, CSAs have unfortunately not fully delivered on their original promise.
8 years later, IRPs are still facing difficulties in fully benefiting from the holy grail of unbundling. Taking note of the rather slow and uneven spread of the CSA/CCA model, last month (february '15) the FCA declared, to the surprise of many:
“Moreover, current commission sharing agreements (CSA) approaches would seem incompatible with the intention of Esma’s proposals, and specifically the view that there should be no link between execution and research payments.” — source
Check & mate.
But the deeper truth is that despite its dynamic and aggressive perception by the public, the financial markets industry is actually one of the most conservative. Even some of government organisations move faster nowadays! Unlike most industries, finance advances mostly under regulatory pressure, and rarely at its own initiative. Lehman's fall painfully increased regulatory scrutiny on the infamous sell-side. It was only a matter of time before it bit the buy-side.
Fragile financial equilibrium, massive regulatory shifts: is it disruption time yet?
MARKETPLACES TO THE RESCUE?
If you ask market professionals how much a 'trading idea' is worth, you will receive a blank stare, without exception. An industry outsider would find it rather odd that one cannot put a price on the very product that helps generate returns. During the heyday of bundling, few players paid any thought to whether advice, good or bad, should be valued. Of course, following the unbundling ‘evolution’, IRPs had no choice but to demonstrate the value of their research content, albeit with little price transparency. Further, their pricing falls short of properly valuing investment advice and is at best an attempt to replicate the investment banks’ model – a yearly fee for an unlimited amount of content.
Nevertheless, against all odds, market forces are already at work laying the foundation for new pricing models. Several factors are making it easier, more than ever before, to connect supply & demand:
- The democratization of financial information;
- Better, cheaper, publishing tools expand the number and diversity of producers;
- More efficient (and effective) distribution over the Internet makes it easier to access;
- Filters and smarter user-matching mechanisms connect buyers and sellers.
These drivers lead inevitably to research pricing become fully unbundled. Furthermore, research itself will be broken into smaller chunks, fostering an emergent à la carte consumption behaviour while simultaneously improving quality by bringing visibility to local expertise. The decomposition of monolithic research products has barely begun, but is already shaping the way for the inevitable birth of a new market.
Sounds promising? There’s just one tiny problem...
PRICE WITHOUT VALUE
Research pricing is sure to evolve and become more transparent. But both current pricing models, free research against execution and subscriptions, still fail to provide a key missing piece of the puzzle:
Sustainable price formation comes from generally accepted valuation metrics, which are still very much lacking in investment research. The industry need to work towards the development of objective measurement techniques and should probably start with the oldest and most basic metric of all: returns. How much longer can professional investors and their advisors seriously avoid performance measurement and accountability?
To fully understand the urgency of the issue, or rather it is ignored, let’s hop over the fence to the retail market for a moment. A host of innovative new companies have already started to establish models where top traders, ranked by their realised returns, are followed by subscribing investors. One might argue that professional investment research embraces vaster subjects and strategic possibilities. Nevertheless, the clear barriers between the two worlds seems to be dissolving as retail pushes ahead in innovation and sophistication without waiting.
WHOM TO TRUST
But is quantitative performance measurement really necessary? Aren’t consensus rankings sourced from trusted industry insiders enough to separate the wheat from the chaff? Close inspection reveals that rankings or industry “grammy-awards” largely favour the bigger suppliers, mainly due to their distribution reach and breadth of coverage, sometimes forgoing quality for quantity. Smaller experts unfairly fail to reach the stature larger players enjoy mostly thanks to their visibility. Ratings are not standardised and can prove to be opaque and manipulable. A risk-adjusted rather than industry-adjusted, approach would most probably be a better basis and more helpful to the investment making process. The essential question to ask is:
Building research rankings through open, standardized metrics is a key component to creating a truly liquid and efficient market. At inception, an investment idea or research note is worth no more than the reputation of its author.
Investment managers must have the opportunity to base their decision-making on a wider choice of unbiased and objectively qualified providers. If research is quantitatively rated, all actors participating in the investment process would benefit from it:
- Investors would benefit from higher returns,
- Asset managers would increase their margins with better use of research spending,
- Regulators would have access to transparent procurement reporting,
- and, finally, more research providers would enjoy healthy economics.
Even banks could happily unload their “not so biased after all” research inventory through innovative distribution channels. The interests of all players in the value chain have never been so aligned in the history of professional investment.
It is time to move forward.