The EU’s unbundling directive is reinforcing the power of scale

A NEW YEAR often begins with a headache. For asset managers and brokers, last year’s pain was intensified by the European Union’s revised Markets in Financial Instruments Directive (MiFID 2), which came into force on January 3rd 2018. Among other things MiFID 2 obliged fund managers (the “buy side”, in industry argot) to pay brokers (the “sell side”) separately for investment research, rather than receive it bundled with trading services.

Twelve months on, predictions that the directive would squeeze research spending and brokers’ revenues, and hasten market concentration, look broadly correct. In a report in November, consultants from McKinsey noted that sell-siders’ commissions from equity trading in Europe had fallen by 30% in a year. Recent signs of consolidation include the purchase by AllianceBernstein, a fund manager and research firm, of Autonomous Research, an independent analysis firm, and numerous takeover rumours involving smaller investment banks and brokers.

Simple economic theory says that if you charge for something rather than give it away, demand will fall. Investment research is no exception. (Typically, a broker will now charge a subscription for written research, plus additional fees for conversations with analysts and other services.) Three-fifths of asset managers responding to a survey of market participants published last month by Liquidnet, a trading network, said they had reduced the number of research providers they draw on.

This trend has further to run, as fund managers compare the value of analysts’ ideas with the size of research invoices. One fund-management executive says that last year’s cuts in analyst lists were just the start; another cull is likely in 2019. Although buy-siders still use dozens of global research providers, the trimming will probably favour bulge-bracket Wall Street firms. Scale not only cuts the unit cost of coverage; big investment banks are also splurging on information technology to carry out ever-fancier computational gymnastics with ever-bigger stashes of data, further sharpening their competitive edge.

The fall in demand for research may not matter much for coverage of big corporations, which dozens of analysts follow. A few analysts will probably not be missed. But for smaller companies a cut in coverage is much less welcome. As an unintended consequence of MiFID 2, more companies are therefore paying brokers and independent providers to write research. This has obvious pitfalls. Conflicts of interest in research are, alas, nothing new. That said, sponsored analysis is surely better than none. Paid research providers also have reputations to maintain and this way the payments are no secret.

Rather than pass charges for research on to investors, fund managers have mainly chosen to take the hit themselves. It is fiddly to have portfolio managers account for every minute spent talking to analysts and then allocate the time among customers. By paying the bills fund managers retain more control of their budgets—and have an incentive to use them prudently.

As well as being a European rule, MiFID 2 may evolve into an unofficial international standard. Instead of having different procedures outside Europe, global asset managers have decided to unbundle research worldwide. More than half of the buy-side respondents to Liquidnet’s survey said they had done so and a further fifth said they would follow suit in the next five years. This makes competitive as well as administrative sense: clients may be drawn to fund managers who subject themselves to MiFID 2’s strictures.

Instead of creating a new trend, MiFID 2 may merely have sped up one that was already under way. Big investment banks have long been pulling away from the pack. The three biggest, according to McKinsey, had increased their share of the top ten sell-siders’ revenue from trading shares for clients by seven percentage points between 2014 and 2016.

Baillie Gifford, a big fund manager, chose to start paying separately for external research in January 2016, two years before MiFID 2 came into force. James Budden, its director of marketing and distribution, says that the firm decided that “we should pay for the research we really valued”. Like other asset managers, Baillie Gifford is developing its own research prowess. It has recruited supply-side analysts and put resources into undercovered sectors (such as small-cap Japanese companies). It also commissions reports from academics and others (on the luxury-goods market in China, say).

Margin pressures on both the buy and sell sides are also an established fact of life. The rise of “passive” investing, in funds that track share indices rather than rely on fund managers actively picking shares, has crimped asset managers’ margins. Brokers’ equity commissions have shrunk as fees have tightened. Both sides are more cost-conscious and striving to be more inventive. If MiFID 2 has sharpened minds on both sides of the market, that is no bad thing. In most markets, after all, you get what you pay for. Why not this one?