Specifically, the concern we raised was the risk that managers who decided to use their own operating budgets to purchase research (rather than use client money via bundled commission rates, soft-dollars, CSAs etc.2) may subsequently face internal pressure to reduce the amount of research they bought in order to maintain adequate profit margins. While this impulse is certainly understandable from a financial management perspective, it must be properly balanced against portfolio management needs so as to ensure the reduction in research doesn’t negatively impact the firm’s investment performance.
In this regard, according to recent research from Evercore ISI3, the 2018 investment performance of managers who chose to pay for research from their own operating budgets significantly underperformed managers who adhered to the more traditional bundled-research/soft-dollar model.4 Even taken at face value, we would not argue that such a finding repudiates the genuine grievances MiFID II was designed to address. However, it does present asset owners with an interesting conundrum. To wit, the immediate appeal of having a manager pay for its own research (and thereby reduce the commissions paid from the asset owner’s fund assets) may have a longer-term unintended effect of hurting the manager’s overall investment returns.
Indeed, beginning in the second half of 2017, an increasing number of global and European managers announced that they would commence using their own money, rather than their clients’ money, to purchase external research. Equally significant, throughout 2018, reports surfaced that a number of those global and European managers had slashed their research budgets by upwards of 50% or more.5 This in turn, begs a second question: Will those managers be able to sustain their historical performance levels after significant research cuts?
Most recently, this same question was posed by the CFA Institute in its 2019 report analyzing the provision of research in the US following MiFID II.6 The bulk of the CFA Institute’s paper focused on the history of MiFID II’s new rules and the potential conflicts faced by managers who use client money to buy research. However, the paper also detailed a number of risks asset owners should be mindful of. In this regard, in projecting the potential consequences of managers cutting their research budgets, the CFA Institute warned that, “lower investments in research by small and midsize asset managers… has significant potential to hurt investment performance for managers and their clients over time.”7
Evercore ISI’s study reviewed the performance data of every available equity mutual fund with at least $100 million in AUM. Because there is no formal repository for tracking which mutual funds pay for research with client money versus their own internal budgets, as a proxy, Evercore ISI compared US versus global and European managers. This decision was based on abundant anecdotal evidence suggesting that the vast majority of global/European managers have switched to using their own P&L for purchasing research,8 while most US-based managers continue to use client money to purchase research (i.e. via soft-dollars, CSAs, etc.).9
For example, based on Zeno AN Solutions’ Peer Group Universes, the typical Small Cap Growth manager currently pays an average bundled commission rate of about 2.2¢ (7 bp), and execution-only rates of around 1.5¢ (4 bp). At the same time, the average turnover rate for Small Cap Growth managers is currently around 75%. This implies that if a Small Cap Growth manager decided to stop using their clients’ money to purchase research, those clients would see an improvement in their annual investment performance of around 4.5 bp.10
At the same time, we encourage asset owners, as prudent fiduciaries, to explore these issues with each of their managers, particularly those who have already chosen to, or who plan to pay for their research costs out of their own budgets. Having said that, asset owners should not be surprised if some managers are unable to provide this information. This was the experience of the SEC in a study they conducted on more than 1,500 managers in July 2018.11 In particular, the SEC noted that many managers were currently unable to: