THE INVESTMENT RESEARCH MARKET: how regulations are driving technology innovation
The post-crisis regulatory environment has had far-reaching effects—impacting processes in the front, middle and back offices. With two regulatory initiatives in the UK, the investment research market is now bracing for change. In this article, Neil Scarth, Principal, Frost Consulting, discusses how regulations are affecting research and, in particular, how they are driving technological change that will ultimately make the process of searching for and using information more efficient and productive.
The institutional equity market, which involves the management of pension/mutual funds, etc., is a unique business model funded by the “currency” of equity commissions. These small charges are added to every stock transaction to pay for the settlement of the transaction itself, and other services, primarily research.
While the individual charges are small, the aggregate amounts are large; execution commission spending was estimated at $11 billion in 2011 and research spending almost twice that.1 The key to this unique arrangement is that these commissions actually belong to the asset owner, yet they are spent by the asset managers.
The execution and research markets have developed differently. Deregulation was used to create competition for stock exchanges, resulting in an explosion of competing trading platforms that fragmented and complicated the equity execution process. The market responded with billions of dollars of capital expenditure on electronic, algorithmic trading tools to allow traders to manage this complexity. This has vastly transformed today’s operational process of trading.
The distribution of equity research—the key raw material for asset manager investment decision-making—has seen little change since the emergence of the Internet. However, like the execution market, regulatory change is beginning to force the adoption of new technologies.
Two critical regulatory measures are having a big impact on investment research. And while these mandates are UK-based, the global nature of the asset management business and the need for managers to treat clients equally and align their multi-regional operational processes will stretch the impact of these regulations well beyond the UK over time.
The first is the UK FSA’s CP-176, which created commission unbundling, or the separation of execution and research components. Previously, the two commission components were bundled together (inseparable) and could only be captured by investment banks and brokers that performed the equity execution. The only way for asset managers to use their client’s money to purchase research was to buy it from brokers. This effectively gave banks a monopoly in the research market.
In the unbundled environment, the research commission could be directed to any type of research producer, not just banks via Commission Sharing Agreements (CSAs). This vastly expanded the asset manager’s research universe.
In order to harness the alpha generation capacity of this wider universe, new approaches to search will be needed. The ability for research producers to publish information in XML chunks will make their research more “findable” in an increasingly complex data universe. The ability of asset managers to develop internal semantic search technologies applied to these documents will result in a search experience that reflects that asset manager’s own unique investment process. In doing so, asset managers can maximize the ROI on client commission research spending by thematically mining the contents (rather than just the titles) of millions of research documents.
Previous commonly used storage/retrieval solutions relied heavily on non-sharable emails or hard drives and were driven by more limited “key-word” search functionality. The new techniques represent a significant productivity increase for investment professionals who spend a great deal of time looking for research material.
The importance of mining this wider content universe is made more acute by the significant decline in investment banks’ research budgets. As depicted in Figure 3, at the same time CSA usage has risen (blue bars), investment bank research budgets (red line) have declined. This is largely due to the negative impact the financial crisis had on most banks’ profitability.
The second UK regulatory initiative started with the November 2012 “Conflicts of Interest” for asset managers. This committed the UK industry to radically change the way it used its clients’ commissions to pay for research. Historically, asset managers conducted an internal “research vote”—a poll of portfolio managers and analysts to determine which research producers provided valuable products and services. The total of those “votes” were usually presented as a percentage of the research commission number, e.g., 7% for Bank A and 5% for Bank B.
Equity commissions, particularly outside of North America, are ad valorum, or calculated as a percentage of the price of the shares being bought or sold. The Financial Conduct Authority (FCA) had an issue with this system because it created significant year-to-year volatility in the research commission number, resulting in an asset manager potentially paying 20 to 30% more for research one year than another, despite the fact that the research products and services being consumed were broadly similar.
“Conflicts” required asset managers to create absolute monetary (rather than percentage-based) research budgets, thus limiting the historic volatility and a theoretically infinite increase in research payments. But as Figure 4 depicts, this will have a significant impact on the industry, particularly for research producers. It will lower cross-cycle returns and likely further reduce research produced by investment banks.
There are other changes in the works. Additional regulatory initiatives and suggestions from the UK Investment Management Association may require asset managers to place a value on the unpriced investment banking research they consume. Some observers believe that this will create a “priced” market for investment bank research that will resemble other specialist publishing markets, where clients can view report summaries yet only receive the full report once they pay for it.
The Impact on Investment Bank Research Producers
Investment banks dominate the provision of investment research to asset managers. Historically, and counter-intuitively, this research has not been specifically priced. Typically, a bank would give a large asset manager access to all of its research (tens of thousands of documents per annum from a large bank) based on the understanding that it would be compensated via equity commissions that paid for both execution and research from the asset manager. As the research was distributed freely to all asset managers that qualified, there was no need to differentiate the format of that research, which was almost entirely PDF. If the industry moves to a priced research environment, suddenly the product received by the asset manager that has purchased the product/service must have greater functionality and utility as compared to products distributed for free to other managers (advertising) that have not purchased the product. This will spur research producers to use technological innovation to distinguish their products from one another—and to provide different consumption experiences for those consumers who have purchased the product and those who are just browsing.
One of the tools enabling change is HTML5—a programming language with great flexibility and customization potential to be positioned as premium products versus today’s “freemium” of the ubiquitous PDF. XML publishing tools also lend themselves to content re-use, reducing authoring time and expense and easily and appropriately creating native formats for mobile devices. While adopting these new technologies and pricing structures will be central to the profitability and market share of research producers going forward, investment managers will reap the benefits as well. As research products become more personalized, more interactive and more findable, asset managers will get greater utility from them, significantly enhancing their own productivity.
As with many areas in the capital markets, new regulations are having a significant impact on the investment research market and could radically restructure the economics of institutional equity research distribution. At a minimum, asset owners will expect more transparency on research spending, and asset managers will need to value and track research usage in a more granular way.
By changing the pricing structure for research, regulators are forcing research producers to use technology to develop tools to help asset managers more efficiently find the information they need. At the end of the day, it will be the investment managers—the consumers of research—who will benefit from new tools and platforms that make finding the information they need infinitely easier.
- Frost Consulting, “Introduction to Commission Unbundling,” July 2012
S. Neil Scarth
has held a wide range of roles in asset management and investment banking in both Europe and North America over the last 25 years, ranging from running equities businesses at global banks to launching and overseeing all aspects of varying asset management products. His portfolio management experience has emphasized financial services including equity long/short (Deephaven Capital International/London and Symmetry Management/New York) and pension/mutual fund advisory (Trilogy Global Advisors/New York). Mr. Scarth’s investment banking experience includes running integrated institutional equity business units for ABN-Amro and Merrill Lynch. Neil is a member of the UK Investment Management Association’s Research Review Advisory Panel. He holds an M.A. from the University of Southern California and a B.A. from Carleton University.