MiFID II research rules to add fiduciary layer for asset owners

Pension fund executives will have another fiduciary responsibility starting as early as next year, courtesy of the European Commission.

New EC rules will require money managers with European operations, clients or investment strategies to disclose, in advance, a detailed budget of research charges that have historically been bundled with execution costs under what's known as soft dollars. Pension fund executives can either accept or reject those charges from their money managers.

And therein lies the new fiduciary responsibility, sources said.

Overall asset owner costs for research are expected to fall by 15% under the new Markets in Financial Instruments Directive II rules, according to a report from London-based Frost Consulting Ltd., which advises pension funds and managers on market structure changes.

That's because asset owners under MiFID II will pay only for research they specifically need for their investments, said Steven Glass, president and CEO of Zeno Consulting Group LLC, a Bethesda, Md.-based consultant to pension funds on trading issues.

Managers that bundle commissions currently use a top-bottom approach, in which a manager uses commissions to pay for all kinds of research — often in asset classes in which asset owners, who are paying through bundled commissions, weren't investing.

“Managers will need to say what they need, what the costs are, and what that will mean for asset owners' pro rata research,” said Mr. Glass. “And because that will now involve the transfer of plan assets, that now makes it a fiduciary decision for a pension fund” — whether that asset transfer will be done for the benefit of its participants.

“Anytime a pension (fund) board is asked to OK a transfer of funds, fiduciary antennas go up,” Mr. Glass added. “There will be a lot of attention to this since it will be a new fiduciary risk.”

Although the MiFID II rules will not take effect until January 2018, decisions on research budgeting will need to be made next year, Mr. Glass said — perhaps as early as the third quarter 2017. That's because budgets will be for a calendar year and, under MiFID II, will require preapproval by asset owners.

“Most pension funds don't have a clue that this is coming down the road,” Mr. Glass said. “That's why we're giving them a heads-up that this will happen. They'll have to judge if the cost of that research is worth it.”

The decision isn't simply one of a pension fund accepting or rejecting research on their investments, said Neil Scarth, London-based principal at Frost Consulting.

“This will be the first time ever that asset managers will be required to propose research budgets to asset owners specific to their investments,” said Mr. Scarth. “It will become very complex for the asset owners as well as the managers, since they will need to decide whether to accept the cost. Those asset owners could have five different managers in the same asset class, but each may have radically different research proposals. What do you as an asset owner do?”

Rejecting a manager's proposed research budget doesn't necessarily mean that the manager won't provide research — that manager may choose to take on the research costs itself. That's far easier for managers with greater scale than others, putting niche money managers at risk of losing business.

But that creates another issue for the asset owner: Why would one pension fund executive choose to pay for research if the executive discovers that other pension funds can get the same research from the same manager for free?

Mr. Glass said managers could turn down business with the asset owner if the budget is rejected, but he added: “That's very unlikely. I can't see managers turning down business for this.”

“This has never happened,” Mr. Glass said. “The industry will have to come up with something to deal with these issues. This will be a big deal, especially to active managers. We think most asset owners will say no to the research, and those who say yes must pay only the agreed research cost. We advise asset owners to see what their commission costs are now vs. what they will be next year.”

Also, managers offering non-European strategies to U.S. asset owners will most likely disclose their research budgets anyway because using two operational systems to manage money — one under EC and one under Securities and Exchange Commission regulations — would be far too expensive and onerous.

“It's too expensive to have two different infrastructures, one in the (European Union) and one in the U.S.,” Mr. Glass said. “This puts managers in a conundrum. If MiFID II bans soft dollars, what do they do with Asia and the U.S.? Do you increase their commissions? There's too much operational risk for managers to have (multiple) systems.”

Another deterrent to managers' using multiple systems is the principle — though not a rule — of equal treatment of clients, Frost Consulting's Mr. Scarth said. “Even in U.S. strategies, managers have global counterparties, global clients. If you manage assets for IBM's pension fund in the U.S. and the U.K., under the letter of the law, you could get IBM U.K. unbundled research while still bundling for IBM U.S. But that would mean a huge change between the two. We know U.S. managers that are not covered under MiFID II, but they will still apply the rules of MiFID II because they treat all clients equally regardless of where they're based.”

Mr. Glass said the SEC isn't likely to adopt a version of MiFID II rules and apply them to U.S. managers because in the Securities Exchange Act of 1934, safe-harbor rules include permission to combine research and trade execution costs. Changing those rules would require an act of Congress, Mr. Glass said, something he's not expecting.

Even with the additional responsibility for asset owners, there's still a benefit from research cost disclosure, said David Weisberger, managing director and head of the trading and quantitative services product group at Markit Ltd., New York.

“In theory, this should result in more precise accounting of the costs involved in asset manager portfolio construction and result in lower trading costs overall for managers that embrace the rules,” Mr. Weisberger said.

“There's additional fiduciary risk” for the asset owner, Zeno Consulting's Mr. Glass said, “but there's also good news out there — more transparency, lower research cost and real savings for the plan.”

“Once all of this shakes out, these pension fund discussions will become part of their due diligence,” Mr. Glass said. “But the transition period (next year) will be a real mess. There are a lot of murky areas in MiFID II.”