Transparency rule will force re-evaluation of research
When it comes to MiFID II, what does not kill active managers will make them stronger.
So say some industry analysts, whose views run counter to a common opinion among institutional investors — namely, that required research-cost transparency under the European Union's Markets in Financial Institutions Directive II will make it more difficult and costly for active money managers to obtain analysis on what stocks to buy or sell.
"MiFID II will force more managers to determine how carefully they use proprietary research to drive alpha," said Jeffrey A. Levi, Darien, Conn.-based principal at money manager consulting firm Casey Quirk, a practice of Deloitte Consulting. "It will drive a winners-vs.-losers dynamic. Some will perform better because of research, some won't. … It's going to accelerate the winner-take-all dynamic in the industry."
Under MiFID II, effective Jan. 3, all financial firms that do business in the EU or have clients in the EU will be required to disclose research costs as a distinct line item, rather than include them in bundled commissions with executions.
Although U.S. managers aren't required to follow the rules for domestic investments and clients, most are expected to comply with MiFID II because of their global reach and the difficulty in setting up two separate infrastructures — one regime to meet U.S. rules and another to follow EU regulations.
But not all active managers will be hurt. Many firms, particularly midsize firms, will be able to fund their own research through the reduced execution costs that are expected to result from the unbundling rule — and use more targeted research to generate more alpha, said Shannon Curley, CEO of the CFA Society Chicago.
For active managers, the benefits of unbundling include the reduced clutter of unnecessary analysis and the potential for greater use of technology to pinpoint what kind of research is providing the most alpha, Mr. Curley said.
"The sell side could be in trouble, but it will make buy-side analysts more valuable," said Mr. Curley. "I don't know of too many active managers who are upset about this rule."
Added Tim Cave, equity research analyst, TABB Group, London, "You'll see a genuinely competitive market for research. It'll be a lot more competitive, and that will lower costs. Fundamentally, there'll be more insight into costs and fees. That sort of reinforces the best-in-breed categories in active management. … Another benefit for active management will come from rules that will bring better execution quality. That hopefully will lead to a flight to quality in that regard."
Iain Douglas, head of emerging markets equity research at Willis Towers Watson PLC, New York, agreed MiFID II's unbundling rules will lower overall execution costs. He also said managers' asset-owner clients ultimately will benefit, too, both through added returns from research and more disclosure of research costs.
MiFID II research unbundling "is good news," Mr. Douglas said. "There's be more transparency on costs, but there'll also be more interesting active portfolios."
Mr. Douglas said he expects most managers to focus on what research they'll actually need because of MiFID II. "If you move to execution-based trading, managers (will) determine what the need for research is and probably pay for it themselves," Mr. Douglas said. "It will be challenging to tell asset owners they'll need to pay more. If you unbundle, however, there'll be less research cost drag on returns because overall transaction costs will be lower. Managers will be more selective of what research they want. And if active returns improve, you might be able to hold off outflows."
The quality of that research will also improve as a result of unbundling, Mr. Douglas added, particularly in avoiding "herding" among managers whose strategies look the same because they're using the same sell-side research. He said managers with more targeted, cost-efficient research could create strategies that "are more different than the benchmark," taking more active positions, and by doing so potentially increase their returns.
"If managers move to pay for research themselves, there's less possibility of herding by managers among a few research providers, leading more managers to use independent firms or also just do themselves," Mr. Douglas said. "There could be more stock-picking than normally had been done. Active management will actually become active. That's nothing but good for asset owners."
Unbundling will also prompt research to be viewed in terms of its actual return on managers' investment, said Charles Poliacof, New York-based chief revenue officer at Visible Alpha, which provides data on investment research to money managers. "If (managers) look at research in terms of return on investment, providers will have to focus on presenting a great research product — for the sell side as a business and the buy side as an investment generator," Mr. Poliacof said. "By asking for unbundling, regulators are putting the focus on best execution and requiring a valuation framework for research. ... With MiFID II, regulation can become a source of ROI."
TABB's Mr. Cave was less certain as to whether unbundling will directly translate into additional alpha, at least on the research end.
"That's still a nebulous concept in terms of research and execution," Mr. Cave said. "That might come to light next year (when MiFID II rules go into effect). But if you're choosing your broker not for research but for their ability to execute, surely that could happen."
And not all active managers will see higher alpha on their strategies from unbundling, said Mr. Levi of Casey Quirk. "You can't pinpoint the impact," Mr. Levi said. "High-quality firms consistently produce high-quality results. Some firms will really differentiate, with new ideas of how to invest. Others may be handicapped by the new rules. Asset managers typically differentiate by having some kind of edge, and a lot of firms already use proprietary content to get that. The regulations could help them get an added edge."n