GREENWICH ASSOCIATES GREENWICH REPORT Q3 2015 A Brave New World for Asset Managers and the Brokers Who Serve Them New rules governing asset managers use of commissions to pay for research in Europe will have a dramatic impact on the industry, even if regulators stop well short of full unbundling. By requiring investors to set research budgets based on specific monetary values for the sell-side products and services they consume, the new rules could prompt asset managers to cut back on the number of brokers they use in order to limit a significant new administrative burden. Consequently, independent providers and global bulge-bracket brokers alike could find themselves in the crosshairs. The end result could be a reduction in the amount and quality of research and advisory services available to investors, especially to smaller institutions that could find their investment teams at a severe disadvantage. Regulators in Europe contend that the purchase of research and advisory services with client brokerage commission payments creates inducements, or at least opportunities, for asset managers to be less than careful spenders. Client interests would be much better served, they believe, by forcing managers to execute client trades at the lowest possible price and pay separately for sell-side products and services. The ultimate goal of some regulators seems to be to require asset managers to pay for research with hard dollars from their own balance sheets, completely isolating the acquisition of external services from both the trade-execution process and client funds. Impact of European Regulations In May 2015, Greenwich Associates interviewed 118 U.S. institutions about the process they use to acquire sell-side products and services and to compensate Study Participants In May 2015 Greenwich Associates interviewed 118 buy-side U.S. equity broker liaisons, heads of commission management, and head traders. Respondents answered a series of qualitative and quantitative questions about the structure of their broker vote process, valuing broker research, and expected influences from the changing regulatory landscape coming out of Europe. Respondent Profile by Average Annual Equity Commission Spend 6% 8% 8% 11% 14% 22% 31% $100 million + $55 million $34 million $23 million $14 million $7 million $3 million brokers and other providers. Rules proposed as part of MiFID II and ongoing regulatory reviews by the U.K. Financial Conduct Authority and the European Securities and Markets Authority (ESMA) were a primary topic of both the study and subsequent Roundtable Discussions with study participants held in June in New York and Boston. Likelihood of Unbundled World in Five Years Total Institutions Greenwich Associates Priorities Net Change 6% 32% 0% 25% 50% 75% 100% Not at all likely Not likely Neutral Somewhat likely Highly likely Note: Based on 90 respondents, including 32 Greenwich Associates Priorities, defined as institutions in Tiers 1-4 of seven. Tiers are determined by institutional commission volume, with Tier 1 containing the largest and Tier 7 the smallest commission payers. Net change represents the proportion expecting it is highly likely or somewhat likely, less not at all likely or not likely. 2015 GREENWICH ASSOCIATES GREENWICH REPORT
Planned Adoption of Global Best Practices Total Institutions Greenwich Associates Priorities Yes 31% No 69% Yes 42% No 58% Note: Based on 67 respondents, including 26 Greenwich Associates Priorities, defined as institutions in Tiers 1-4 of seven. Tiers are determined by institutional commission volume, with Tier 1 containing the largest and Tier 7 the smallest commission payers. We will have unbundling in some form. It s coming. Forty-four percent of study participants think it is somewhat or very likely that global markets will be fully unbundled in the next five years. That share jumps to 60% among large U.S. institutional investors those generating at least $20 million in annual equity brokerage commissions. We will have unbundling in some form, said the Head of Commission Management for a global multi-product asset manager. It s coming. Large institutions are more apt to see unbundling as inevitable because most of them have operations falling under the jurisdiction of European regulators pushing for the change. This issue doesn t rate high on the list of priorities for domestic U.S. managers, many of which are not even following the matter too closely. Of course, we think that is a mistake, as best practices once they are established have a tendency to spread around the world, says Greenwich Associates consultant John Colon. Perhaps more importantly, should larger global managers reduce their expenditures for research, it will likely impact the availability of sell-side research to managers of all sizes. Although it remains unclear just what European regulators will decide or how regulators in the U.S. and other regions will respond, some of the very biggest U.S. asset managers are already planning to establish global best practices based on new regulations out of Europe. Four of the five study participants generating at least $100 million in annual commission spend say changes required to comply with any new European regulations will also be applied to other markets operating under the jurisdiction of their respective regulators. Among all institutions participating in the study, only 31% say they would adopt rules from any European initiative as global best practice. Some of these institutions do not operate outside the U.S. and, therefore, would have no immediate incentive to consider European rule changes. Based on the response from the largest institutions in the study, we believe many multinational firms will move to establish a single global standard when actually confronted with the realities of the new rules and the complexities of maintaining entirely different business practices in different jurisdictions, says Jennifer Litwin, Greenwich Associates Head of Relationship Management. The Hidden Costs of Unbundling Implementing the changes required to set more precise valuations on individual sell-side products and services will impose real financial and administrative costs on the buy side. As one study participant explained, This will put a strain on commission budgets, small broker-dealer relationships and resource usage in general. It will also require a lot of work from the buy side to synthesize their trading with their budgets. This will be like best execution. Despite not having a real definition, it will morph into an important part of many buy-side processes. Several research participants said a move to unbundling or a shift to hard-dollar payments would place smaller buy-side firms at a disadvantage. Were the U.S. to GREENWICH REPORT 2
Allocation of Overall Research Spend with Brokers By Type Mid-sized/Smaller regional and sector specialist broker-dealers Non-brokerdealer third parties* 20% 30% 50% Bulge-bracket broker-dealers Note: *Including providers such as Bloomberg, FactSet, Reuters, etc. Based on 88 respondents. adopt the regulatory proposals currently being considered by others, it would have an extremely significant influence on our broker vote process and commission management, said a representative of a small U.S. investment management company. The potential influence on access to critical research services and products for smaller firms, and the disparity it would create within the industry, would be extraordinary. The institutions in the study say rule changes now being considered in Europe could have quick consequences, even in the United States. To be sure, a majority of investors in the study (50-60%) say they don t think European regulatory proposals will affect the overall amount they spend on research or the amount of research and advisory services they consume from global investment banks, broker dealers, country or sector specialists, or independent research providers in the coming 12 months. In almost every case a substantial share of study participants often more than 20% simply answered, Uncertain. However, a full 25% of the study participants think the availability of small-cap equity research will decline in the next 12 months as a result of the regulatory changes. Much more ominous to the sell side is the fact that 37% of the investors in the study say they expect the actions of European regulators to cause them to reduce the total number of brokers they use for research and advisory services within the next year, and 36% expect rule changes to prompt cuts to the number of brokers they use for trading. As part of its annual Global Equities Research Study, Greenwich Associates asks buy-side organizations about changes they expect to make to their broker lists. For at least the past decade, institutions have signaled their intent to trim the number of brokers they use for both trade execution and research. Not only have institutions failed to follow through on those intentions every year, broker lists have actually gotten longer. The reason: Institutions have had little economic incentive to cut broker lists, and eliminating research providers Influence of Current European Regulatory Proposals on Use and Availability of Research Over the Next 12 Months Use of research from global investment banks Use of research from country or sector specialists Use of research from independent research providers Use of in-house research Availability of research on small-cap companies Provision of corporate access by broker-dealers Net Change -11% -8% -5% 23% -19% -23% 0% 25% 50% 75% 100% Little or no change (+/ <5%) NA/Uncertain Note: Based on 85 respondents. Net change represents the proportion expecting an increase or significant increase less those expecting a decrease or significant decrease. GREENWICH REPORT 3
Influence of Current European Regulatory Proposals on Number of Brokers Used for Research and Trading Over the Next 12 Months Net Change Used in total for research/advisory services -37% Used in total for trading -36% 0% 25% 50% 75% 100% Little or no change (+/ <5%) NA/Uncertain Note: Based on 85 respondents. Net change represents the proportion expecting an increase or significant increase less those expecting a decrease or significant decrease. especially creates a risk of missing out on a trade idea that could have a meaningful impact on investment performance. New regulations even if they stop short of full unbundling could change that equation by increasing the costs of supporting sell-side relationships in terms of time, administrative burden and money. Transparency and the Buy-Side Budget At the very least, regulators are determined to increase transparency into how asset managers spend client funds, how exactly they determine the value of research and advisory services, how they pay for those services and what value they receive in return. Complying with these rules will require more than just a better accounting process. At present, most U.S. asset management firms have no specified method for assigning value to any particular piece of research. Rather, they give portfolio managers and analysts nearcomplete autonomy to determine the value of sell-side products and services within the context of their own Method of Determining Overall Research Budget Bottom-up Variable 15% Uncertain/ Other 37% 6% 42% Top-down Note: Based on 84 respondents. portfolios and decision-making processes. Investment teams then weigh in on how providers should be compensated through formal broker vote processes. Most institutions 42% of institutions in the study and 50% of the largest participants use a top-down budget process that sets the total annual commission payment budget, which is then allocated through the vote. Many institutions use precedent as a baseline, referring to the amount paid in prior periods as a starting point for the current budget and adjusting for any variation. Others describe a variable overall budget based on actual commissions generated for a period. Very few buy-side institutions only 15% of all study participants and about one in 10 of the largest use a bottom-up process starting with the actual value delivered by particular brokers. Almost no institutions only 2% of study participants have an internal pricing list that sets standard values for broker services. We are not there yet, said a representative of a mid-sized U.S. asset manager. We are still trying to decide if we need to go that far. The inputs are correct, the value is the challenge. The interactions from the brokers are too confusing and don't align with other brokers, and that makes the data analysis very tough and not meaningful. Not only will asset managers have to invest in the IT and personnel required to administer the increasingly complicated procedures needed to assign specific value to research products, firms will also have to demand more detailed feedback from portfolio managers and analysts who will be forced to divert time from their portfolios. These are the costs that could prompt asset managers to start cutting broker lists as a means of reducing the administrative burden. It s just not manageable with too many brokers, said one Roundtable participant. GREENWICH REPORT 4
If the changes do trigger cuts to broker lists, the entire sell side will feel the impact. Everyone looks at this exercise and thinks we ll just cut the tail off we ll just cut the last 30 or 40 brokers on the list, said the Head of Commission Management at a large global fundamental equity asset manager. But that's not necessarily the case. If you do this right, a couple of bulge-bracket brokers will go away. That s where the money is and that s where the overlap is. Institutions expect that a mandated shift in the direction of hard-dollar payments would trigger an expansion of in-house research capabilities. It s fair to question how realistic it is to expect that investment managers, absent the ability to raise fees, will in fact take on additional costs in the form of either hard-dollar payments for research or bringing research in-house, says John Colon. If such a change does come to pass, it will obviously favor large institutions that can better absorb the cost and spread expenditures across multiple strategies and products, while placing a real strain on smaller asset managers with limited resources. The Amorphous Value of Sell-Side Research Participants in the Greenwich Associates study agree that the buy side is moving toward a more transparent accounting of its research expenditures, regardless of the final outcome of the current European regulatory process. Clients are demanding more information about how their funds are being spent. Brokers trying to maintain profitability in an era of declining equity trade commissions are pushing for more detailed information that will enable them to better assess the profitability of research and trading relationships and There s no way around it: It s a new world of transparency. It s gonna get granular. allocate resources more efficiently. And regulators in both Europe and North America are looking closely at issues like best execution, the use of client commissions to pay for corporate access and other parts of the equity trading and research business. There s no way around it: It s a new world of transparency, said a buy-side commission management professional participating in a Roundtable Discussion. It s gonna get granular. Roundtable participants described the difficulty they face in assigning a set value to research. The same meeting with the same people can have different values for different strategies, or even for the same strategy at a different time, said one participant. This makes it almost impossible to create a dollar budget and allocate down to the client account as required by MiFid II. How does the budget get adjusted for lower trading volume or loss of accounts, or if a sell-side firm lets a favorite analyst go? If regulation is imposed, we will have to consider trading execution-only and pay for research with hard dollars. I do not need a large number of execution-only brokers. Anticipating Change Although many institutions say they have no formal method at all for determining appropriate prices for individual sell-side products and services, several Influence of Current European Regulatory Proposals on Research Budgets and Payment Method Over the Next 12 Months Net Change Overall research budget, including hard and soft payments -5% Overall commission spend for research/advisory services Hard currency payments for research/advisory services -14% 14% 0% 25% 50% 75% 100% Little or no change (+/ <5%) NA/Uncertain Note: Based on 85 respondents. Net change represents the proportion expecting an increase or significant increase less those expecting a decrease or significant decrease. GREENWICH REPORT 5
institutions participating in the Roundtable Discussions said they have begun developing processes to more precisely assign value to research. The Head of Commission Management for a global multi-product asset manager said her firm is requiring investment professionals participating in the broker vote process to provide more information that can be used to determine value. First we need to know what the content is. Explain it to me, she says. Then I need to know the frequency and some sense of the impact it had. Did it trigger a decision to trade or not to trade? With this information I can back into a sense of the value. Commission management professionals are questioning why the onus of assigning specific values to sell-side products and services is falling on the buy side. Think about it, in what other industry does the buyer set the price? one asked. Several discussion participants said they have seen new pricing lists from brokers. They describe these developmental lists as completely lacking in consistency not only in terms of actual prices, but in the methodology used in determining value and setting prices. Another issue complicating the process is simply gaining an accurate accounting of what products and services brokers deliver, when and to whom. As of now the process for reconciling what brokers say they provided to investment teams and what analysts and portfolio managers say they received is a cumbersome and timeconsuming part of the commission management process. If regulations require the buy side to account for the cost of each and every piece of research and service they consume, the process will become a deadly serious compliance procedure. It will become an audit. Like a payroll, said a professional who runs the broker vote for a large U.S. equity manager. It s going to be more tedious, a nightmare, and more work for us. But at least we will still have jobs. n Greenwich Associates is planning to extend its series of Roundtable Discussions on Research Budgeting and the Broker Vote in the months to come and to conduct additional research among asset managers after European regulations are unveiled. To participate in the research or in the Buy-Side Roundtable Discussions, please contact Will Llamas at +1 203.625.4310 or William.Llamas@Greenwich.com. John G. Colon is Managing Director of Banking, Markets, and Market Structure and Technology. He advises on the institutional equities market and market structure issues globally. Jennifer Litwin and William Llamas lead Greenwich Associates relationship management efforts with the buy side. Methodology In May 2015 Greenwich Associates interviewed 118 buy-side U.S. equity broker liaisons, heads of commission management, and head traders. Respondents answered a series of qualitative and quantitative questions about the structure of their broker vote process, valuing broker research, and expected influences from the changing regulatory landscape coming out of Europe. All respondent institutions in Greenwich Associates Equity Investors research are placed into one of seven tiers, based on their aggregate cash equity commissions generated. Greenwich Associates Priorities are the largest commission generators, comprised of Tiers 1-4. GREENWICH REPORT 6
The data reported in this document reflect solely the views reported to Greenwich Associates by the research participants. Interviewees may be asked about their use of and demand for financial products and services and about investment practices in relevant financial markets. Greenwich Associates compiles the data received, conducts statistical analysis and reviews for presentation purposes in order to produce the final results. Unless otherwise indicated, any opinions or market observations made are strictly our own. 2015 Greenwich Associates, LLC. Javelin Strategy & Research is a division of Greenwich Associates. All rights reserved. No portion of these materials may be copied, reproduced, distributed or transmitted, electronically or otherwise, to external parties or publicly without the permission of Greenwich Associates, LLC. Greenwich Associates, Competitive Challenges, Greenwich Quality Index, Greenwich ACCESS, Greenwich AIM and Greenwich Reports are registered marks of Greenwich Associates, LLC. Greenwich Associates may also have rights in certain other marks used in these materials. GREENWICH REPORT 7
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