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Mike Tyrrell: Fuel or fig-leaf? The impact of EU's MIFID II on responsible investment research (Part 1)

Part one of a two-part look at the implications of MIFID II for RI and ESG research.

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Is SRI an investment discipline for grown-ups or a fig-leaf for wannabe campaigners? Is corporate governance (CG) a value-creator or a retirement home for bureaucrats? In 2018 we’re going to find out as an unintended (but highly desirable) consequence of the MIFID II European Directive!
Most people in the SRI/CG industries will share MIFID II’s broad aims of making European markets safer, more transparent and more efficient, thus restoring investor confidence. They are also likely to applaud the expectation of transparency and the tougher standards applied to investment products through the value chain. Whether they are prepared for the implications for their own sector remains to be seen.
The impact of MIFID II on SRI/CG depends on the extent to which you agree with the following statements:

  • SRI is primarily an investment strategy
  • Research is the fuel which drives a priori investment decision-making
  • Direct engagement matters

Although these statements may sound self-evident, consideration of contrary positions indicates that many people in SRI/CG have different views, notably that:

  • SRI is primarily an ownership process, an approach to public policy engagement or a means of satisfying client expectation
  • ESG factors manifest primarily through risk exposures and are best tackled a posteriori
  • The complexity of engagement necessitates careful preparation and collaborationIf you agree with the latter set of statements, then MIFID is unlikely to affect you much as your primary driver isn’t investment-related and it follows that you won’t be (and certainly shouldn’t have been) using dealing commission to pay for SRI/CG research or access to companies.
    If, by contrast, you think that SRI/CG are factors that affect asset managers’ decisions to buy, hold or sell stock, and that high-quality research is needed to inform these decisions and that direct contact with the companies in portfolios is a critical source of information, then you are likely to be significantly affected by MIFID II implementation. You are also probably well-advanced in changing the way you pay for investment research and corporate access.
    MIFID II rules that asset managers should no longer pay for the research or corporate access services that they receive bundled into trading commissions. Instead, payment should either come out of the asset manager’s own pocket or, if the end client is to pay, the research/access costs should be separately identified, both at the payment stage and at the point of client reporting. In theory, this sounds simple. In practice, however, it introduces major new competitive dynamics into the SRI/CG research market, notably:
  • Usually, it causes sell-side broker research to be paid for out of the same budget pot as SRI / CG research
  • Often, it causes external research to be paid for from the same budget pot as internal research
  • Always, it forces asset managers to be more disciplined about the research and services that they receive and to report more transparently to clients about the use that they make of these.
    The first of these competitive elements increases massively the client ‘wallet’ available to SRI/CG research providers. But, it also exposes them to the viciously competitive pricing strategy that some ‘sell-side’ brokers are adopting. The second should cause asset managers to ask the following question about all research spend: are we best to ‘build’ or ‘buy’ from outside? Does this research yield competitive advantage we want to own or is it more efficient to source from an external provider via an openly accessible research market?

For asset managers: A buyers’ market
The third competitive factor is potentially the most interesting because MIFID not only goes a long way to creating an open market in investment research but also ensures that it is ‘a buyers’ market’. The longstanding oversupply of investment research capacity will reverse and through the first stages of the painful (to big-suited brokers only) transition process, buyers (asset managers) will have the whip-hand. As Roy Orbison might have sung: you want macro-economic research? You got it. You want sustainability research? You got it. You want research on South Korean companies with names beginning with the letter ‘B’? You got it.
Of course, as the research wallet decreases, the overall volume of research will shrink. However, there is ample scope for differentiation by individual research providers that SRI/CG focused asset managers could exploit to reshape the future market.To achieve this, the research buyers will need to have a clear idea of their desired destination. As a result, I think we could reasonably expect within three years to see any multi-strategy asset managers who are serious about SRI/CG structuring their research around the following possible solutions:

  • An internal research team who undertake proprietary research, purchase and use research from third parties including
  • One (or maybe two) waterfront data / ratings providers
  • Around 8 – 10 in-depth sector/country/issue specialists (which may include ‘sell-side’ brokers, credit ratings agencies or independent SRI/CG providers who will bring depth and different dimensions to the research received from core providers
  • A panel of 10 – 20 subject specialists who may (or may not) be commissioned on a project-by-project basis to investigate particular themes, opportunities or risks.

Although this may seem a world away from current practice, it seems likely that improvements in market
competitiveness, efficiency and research buying processes will enable this broader and deeper research to be sourced at a lower price than the current suite of research received by asset managers. (It is also predicated on the fact that asset managers are massively overpaying for SRI/CG research currently by paying for access to research rather than research they actually use.)
In addition to having a clear idea about their desired destination, asset managers will also need to have:

  • Tight control of their research budgets (which good commercial practice or MIFID requires anyway),
  • A clear articulation of their own needs
  • A robust process for discriminating between different research providers and
  • An ability to describe to clients how this research spend translates into desirable investment outcomes (again required good commercial practice or by MIFID).

Finally, they will need to have a close eye on efficiency and leverage. They will need to ensure that they buy different types of sustainability or corporate governance research from the firms that are best able to deliver that research. This will often involve assessing therelationship between the type of research required and the core capabilities of the research provider. There is no point expecting ‘integration-orientated’ research from firms without valuation capabilities, just as there is no point trying to source fixed income-orientated research from equity research firms or consensus-challenging research from analytics firms or, vice versa, comprehensive datasets from opportunistic stock picking firms.

For asset owners: a chance to discriminate
Under MIFID, asset owners should expect lower fees as competition drives research costs down. They can also expect greater transparency from asset managers as research costs and the value that these are used to deliver become a point of competitive differentiation. This latter factor will enable owners to differentiate between asset managers that are actively using sustainability and corporate governance information to make investment decisions (integration) and those that are using research for other purposes. The simple question: “How are you using research to deliver sustainable investment outcomes?” will continue to be a useful way of dividing the sheep from the goats of sustainable investment … but now all European asset managers will be required by law to give an answer to it.

For independent research providers: a double-edged sword
MIFID’s requirement that investment research be paid for independently and transparently from dealing commission removes the different payment channels
being used by sell-side brokers and independent research providers. On the one hand, MIFID II increases the size of the client wallet available to SRI/CG research providers from an estimated $150 million (SRI-CONNECT estimates) to $12-15 billion (market estimates vary widely). On the other hand, it exposes them to the brutally competitive pricing environment being applied by ‘sell-side’ providers. The 1:8:20 scenario that I posited earlier about the future shape of any individual asset manager’s research roster might result in a global market of 5 waterfront providers, 40 in-depth providers and 100 focused specialists (for whom SRI/CG will often be a subsidiary business interest). As this is not the shape of the global SRI/CG research market today, significant disruption can be expected and we eagerly await the results of the IRRI 2017 Survey (end of Jan 2018) for clues on the direction and speed of travel here.For the ‘sell-side’: an opportunity to differentiate
As noted above, ‘sell-side’ investment providers are currently engaged in a struggle to establish position in this new ‘buyers’ market’. They are deploying price (in some cases, brutally!), access to broader services and research quality in this competition. We cannot, at this stage, discern a pattern to the way SRI/CG research is being treated – although this may become clearer after last year’s bonuses are paid. There has neither been a flight from SRI nor a foray towards it … which, we suspect, should not be cause for complacency. If asset managers want SRI to remain and become an integrated part of the sell-side research suite, now is the time to make it clear to their colleagues and ‘sell-side’ providers alike that this broader research perspective is recognized and rewarded in the selection of investment research providers.

Mike Tyrrell is Editor of SRI-CONNECT

Disclosure
It would be disingenuous of me to complete this article without acknowledging that the business that I run: SRI-CONNECT is positioning itself to support the changes necessitated by MIFID II implementation and benefit from the opening up of global markets in SRI and corporate governance research.
Contact me to find out more. Or, best of all, challenge my views by sharing your own perspectives on this ongoing debate via Responsible Investor, LinkedIn or SRI-CONNECT.

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