Active equity managers who've seen institutional clients move toward more passive investment in recent years have another potential roadblock to navigate in upcoming European regulations requiring research cost disclosure.
The Markets in Financial Instruments Directive II, set to begin on Jan. 3, 2018, will require firms that do business or have clients in the U.K. and European Union countries to specifically disclose to clients the amount it charges them for research. While the Securities and Exchange Commission will continue to allow bundled commissions to incorporate research and trading execution in the U.S., most large money managers are expected to follow MiFID II rules globally as a matter of best practice, with other, smaller U.S.-based active managers following suit by demand of their institutional clients, sources said.
“Research needs obviously are greater for active managers,” said Steven Glass, president and CEO of Zeno Consulting Group LLC, a Bethesda, Md.-based consultant to pension funds on trading issues. “The full size of that research has never been scrutinized. The first time managers provide these (research cost) notices to asset owners, there could be sticker shock. And that's exacerbated by managers having to get approval (from asset owners) to get the research. Managers will have to prove those costs are justifiable.”
Sources said the timing of the MiFID II requirements could coincide with a more volatile market, which could make active management more attractive.
“I am concerned that MiFID II could be an artificial stimulant tipping the scales toward passive management at a time when natural market forces are already at work creating greater demand for transparency and improved market returns,” said Thomas Conigliaro, managing director, global head of brokerage and research services at analytics provider IHS Markit Ltd., New York. ”We may be on the brink of increased equity performance, higher yields and higher volatility, which would naturally favor active management. The question remains whether these draconian regulations, designed to significantly impact active managers more than passive, may be occurring at an inflection point where active managers' performance is poised to improve.”
Added Jack Pollina, managing director and head of global commission at brokerage and financial technology provider Investment Technology Group Inc., New York: “In the market we're under, passive has made more sense. But as volatility enters this market, I think active management may be a better play over time. But (unbundling) will give more transparency. Pension funds now will know exactly what they pay in commissions, research, execution. They'll be able to ask, "Why did one (manager) charge more than another?' It will create more dialogue. The asset manager will call out the broker. There'll be a lot more of that going on. I don't know if unbundling will be a driver to passive; I think most investors will still go with the best return.”
Jeffrey Levi, principal at money management consultant Casey Quirk, a practice of Deloitte Consulting LLP, Darien, Conn., said he's seen “a real emphasis on portfolio cost vs. expected returns” from asset owners. “That ratio has been going up for years. Manager fees that were in the 10% range are now twice that because of return declines. That's why assets owners have reacted with passive investment and insourcing. MiFID II will accelerate this trend.”
Passive investments as part of large U.S. defined benefit funds' overall U.S. equity allocations have increased over the past two years, according to data reported in Pensions & Investments' annual survey of the nation's largest retirement plans. Passive U.S. equity allocations comprised 54% of all U.S. equity investments for the largest 200 DB plans in terms of assets as of Sept. 30, compared with 51% two years earlier. Active, meanwhile, comprised 38% of U.S. equity allocations as of Sept. 30, down from 41% two years prior.
Zeno's Mr. Glass said that, ultimately, asset owners will consider active management from either a quantitative or emotional perspective — with a quantitative view benefiting active managers while the emotional will target the increased research disclosure as yet another cost of active management at a time when asset owners want to reduce fees.
From a quantitative view, Mr. Glass said there are four benefits to active management from MiFID II: lower research costs, better execution, improved returns and more targeted analysis.
“Changes that MiFID II will cause will only help active managers,” Mr. Glass said. “The most obvious reason is MiFID II rules will make the process managers need to follow for research costs more efficient than it has been historically. Today, I'd bet most managers couldn't tell you exactly how much research costs. We heard (through consultant Frost Consulting) that research costs are expected to fall 15% to 20% under MiFID II, because (the) only research that will be bought will be for specific client needs.”
Execution will improve, he said, because selecting brokers for trades will be based solely on execution quality and not linked to research agreements that could previously have driven the selection of a broker.
“Returns could bump up slightly because under MiFID II, managers can't do cross-subsidization, using equity research costs to pay for other kinds of research like fixed income. The research will pertain directly to the specific investment,” Mr. Glass said. “And MiFID II requires managers to think about research needs — what services truly provide value for certain investments. It links an actual value to an investment product. I think that's a healthy practice that will help investors.”
The first year under MiFID II will be the hardest, said Zeno's Mr. Glass. “If you're emotionally already leaning toward passive, the first year of MiFID II, learning exactly what you're paying for research, that's going to be a hurdle, a challenge. If managers can survive that first year, the risk becomes much less. If after all the angst, the asset owner says OK to the research budget, the next year is more about what's changing from year to year. So, for active managers, the critical year will be the first year. In the next six to nine months, invoices will be reaching asset owners' desks. That will be the real test.”
Jeremy Wolfson, chief investment officer of the $10.3 billion Los Angeles Department of Water & Power Employees' Retirement Plan, said that while his plan's $5.3 billion equity portfolio is 80% active, he could see where “the new mechanics of MiFID II and the disclosure of the research fees may create headline risk, which could result in some funds re-evaluating their current passive/active exposures.”
Mr. Wolfson said the increased transparency driven by MiFID II “is good for everyone. It may create some uneasiness at first, however, that should lead to more constructive conversations around fees that are charged to clients ... Fees are an important factor in evaluating new and existing mandates, however, it is not the only factor. Investors should also consider net-of-fee, risk-adjusted returns with investment managers that can generate sustainable alpha across an entire business cycle.”
Money managers contacted for this story would not comment with attribution, with many citing their firm's policies that restrict comment on regulatory issues. But one, who spoke on condition of anonymity, said the best time for active management is when regulations change. “With all the nuances and changes, a great active manager is able to navigate the uncertainty and find opportunities,” he said.
This article originally appeared in the February 6, 2017 print issue as, "Active managers facing new hurdle".