Commentary: Sell-side research struggles to show its worth

Editor’s note: In a previous version of this article, BlueMatrix mistakenly claimed that Wellington Management and other parties had endorsed the adoption of a regulatory framework, akin to MiFID II, in the U.S. This statement was inaccurate and the piece has since been updated to reflect this.

Updated with corrections

It's been more than a year since the European Union's Markets in Financial Instruments Directive II regulation forced asset managers with EU interests to unbundle research payments from the trading commissions they pay to brokerages.

So far, what we've learned from the new transparent pricing model is that the availability of research significantly outweighs the buy side's need for it. Look no further than BlackRock slashing its Europe, Middle East and Africa research budget by 60% in 2018, or the Financial Conduct Authority's claim that MiFID II saved U.K. equity investors more than $200 million in its first year alone.

While discussion continues, the Securities and Exchange Commission's temporary no-action letter enables temporary compliance with MiFID II research provisions in a manner that's consistent with U.S. federal securities laws. This will expire on July 3, 2020, by which time the commission must decide whether to roll out new regulation, take an opposing stance or extend their period of no-action on the subject.

The debate is a time-sensitive one. As regulators spend time assessing the impact of MiFID II's research provisions, to determine whether further rule-making is required, domestic asset managers are absorbing research costs. One method of this is through the client commission agreement, a type of soft-dollar arrangement whereby a money manager pays their brokers executing a trade before asking them to allocate part of the commission to an independent research provider. Until consensus is reached on how to better align research consumption with Europe, this pattern of increased spending will continue.

Under new scrutiny and cost pressures, asset managers, pension fund professionals and the investors they ultimately report to will shift their focus, reprioritizing quality over quantity and spending only on products they believe will provide an edge.

This isn't the end of research, but it is the end of research distributed scattershot throughout Wall Street. News that major U.S. asset managers are clamoring for research pricing reform saddles the sell side with an existential threat. How do they pivot from the pre-MiFID model of winning order flow, where bundled research incentivizes the buy side to route trades their way, to a "research-on-request" format that inverts the status quo?

The first step is looking to asset managers in Europe, who are further along in the acclimation process with a year's worth of historic research payment and consumption data under their belts to glean insights from. The savviest institutional investors will be asking their investment managers how they can tap into these datasets to revise their own frameworks for assigning value to investment research.

Investment managers must also revise their criteria for selecting research providers, paying careful attention to the rising risk of missing investment opportunities in companies that have been assigned fewer analysts due to sell-side budgetary constraints. This threat is affirmed by a recent survey of European fund management professionals conducted by the CFA Institute, in which almost half of respondents (44%) reported a decline in the quality and quantity of coverage of small- and midcap companies.

Seekers of quality investment research must also look to new destinations for the niche research required to develop competitive asset management strategies. Some star analysts, already seeing the writing on the wall, are leaving bulge-bracket firms to join independent research shops that operate on subscription-based revenue models. Under these business dynamics, analysts with superior ability to choose winners and losers will be able to command a premium for their services based on merit.

The trade-off for analysts, however, is they may need to limit their pool of subscribers to avoid blunting the impact of their work by distributing it too widely. As a result, analysts will need to adopt security and tracking software that monitors research consumption by their paying audience. Doing so will ensure proprietary insights aren't being reshared and allow analysts to customize their research for greater value.

The same is true on the buy side. Large asset managers are already employing tracking software to determine which research reports provide the greatest benefits for their in-house team. New interactive report formats like HTML5, which more closely resemble fully functioning websites, provide firms with an opportunity to identify the value of individual sections or elements of a report. Quite often, it's not the qualitative insights that have the most value but the financial models being deployed. Adding to that, HTML5 reports are far easier to engage with and pull out critical information. Investors typically receive thousands of emails with individual PDFs that they don't have time to open, much less root through.

But like anything, there are trade-offs. Institutional investors who interact with HTML5 reports are wary about their actions being tracked or revealing information about their interests or strategies. This underscores the need for buy-side consumers to confirm whether any new electronic research forums they interact with provide some form of limited anonymity, such as a 90-day embargo to protect their investment activities.

All obstacles aside, one thing investors have confirmed is that the need for research remains strong. Active managers still need independent, outside research to either validate or challenge the house view. But MiFID II has exposed a breakdown in communication between the buy side and the sell side. For years, the sell side treated the buy side as a dumping ground for dubious product. Now, the buy side wields immense power — a development similar to the consumerization seen in other industries, such as e-commerce — and only the most credible and useful providers will survive.

We're not there yet, but the need for a revised research valuation framework will prompt investors to review new tools and technology platforms that can evaluate what's for sale, make informed purchases, grade sell-side analysts on the quality of their work and rate pieces of research accordingly. These features will take precedence over traditionally important buy ratings, sell ratings and price targets.

The good news for winners in this new-look marketplace is that they may be able to wring higher profits by leaving behind a model that had been thoroughly commoditized and unable to inspire best-in-class research. The "bad" news for these winners is that they'll likely be lonely.

Patricia S. Horotan is co-founder and managing partner of BlueMatrix I LLC, New York. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.