The challenges of regulation

Tuesday 15 August 2017

From 3rd January 2018, MiFID II will significantly alter the operating landscape for investment firms. I fear the costs of implementing this legislation, from additional workload, increasing the barriers to new entrants and reducing sell-side research, will far outweigh any potential for greater transparency and cost reduction for investors.

Our biggest concern relates to the rules which will require fund managers to pay for research from ‘sell-side’ analysts. Fund companies will be prohibited from receiving analyst research for ‘free’ in return for placing trades with brokerages or banks and will need to provide their investors with a clear breakdown of the cost of research. One of the goals of MiFID II was to make asset managers think about the true value of research they receive and strip the implicit cost of that research from trading fees. In short, increased transparency around the true cost of trading was intended to lower costs for investors.

Under the proposed regulations, there are choices available on how to pay for research. At one extreme, payment is made directly by the asset management companies from their own resources. This option is more onerous on smaller investment businesses as they are typically less profitable, operate with lower economies of scale and will have less scope to absorb these costs. Fund managers have the option of passing this additional cost on to investors through higher fees. I expect few will do so.

Alternatively, there is a complex mechanism which requires asset managers to assess the value of substantive pieces of research, and to pay for it from what is known as a Research Payment Account (RPA). Larger firms which generate a significant amount of commission from trading, either as a result of size or high portfolio turnover, are likely to have larger RPA’s from which to fund research.

Smaller asset managers with low portfolio turnover will generate a lower level of commission to fill the RPA. In addition to the management burden of assessing research and managing the RPA, and dealing with other MiFID II requirements such as ‘enhanced’ trade reporting, this clearly puts a higher burden on any new entrants who wish to receive sell-side research. Raising the barrier to new firms will restrict innovation and customer choice over the longer term. Most research distribution is electronic with virtually no marginal cost of dissemination. Despite the heavy lobbying over the Extel voting period, most research has marginal value and frequently falls into the ‘commentary’ category. However, every now and again we come across an analyst marketing an unpopular view that we consider to have merit and this sets us off on our own research. It is impossible to predict where these nuggets will emerge.

Both buy and sell-side benefit from dialogue and sharing ideas. It is often very useful to know that sell-side analysts are negative. It will be interesting to see how the industry incorporates these perspectives into the assessment of substantive research! Nevertheless, early indications from the sell-side suggest that smaller fund managers will have to target their commission pool in a much more focused manner if they wish to receive research. Whilst there is clearly some logic in focusing any scarce resource, it is likely the majority of commission will migrate to the larger firms which can offer wider coverage. The financial crisis in 2007/8 highlighted the inherent risks in the concentration of capital and ideas.

The direction of MiFID II, whether intended or not, clearly favours larger fund companies who can pay for research from significant commission budgets and further raises barriers for new entrants to the investment industry. It will also hasten the decline of mid-sized and smaller brokerage firms, many of which provide pockets of high-quality research and provide good customer service to their clients, whether corporates or buy-side investors. We have yet to meet an executive from the buy or sell-side who believes the proposed regulation is fair for smaller companies.

Pressure is increasing from investment banks to fund managers on the issue of corporate access. MiFID II prevents access of corporate management teams to shareholders or potential shareholders from being bundled into commission. This practice comes from the mistaken belief that investment banks are the customers of corporates and who then act as gatekeepers between the company and their investors.


It is the duty of investor relations teams to inform existing shareholders, in addition to trying to attract fresh interest from other potential shareholders. Similarly, a fund manager has the responsibility to maintain regular and timely contact with their investors. In an attempt to develop our business, we also spend a great deal of time with potential investors. The requirement to have an investment bank paid to enable a corporate to meet a shareholder is absurd and I hope this will be robustly resisted.

This process of disintermediation and measurement has many consequences: not all are negative. Whilst we remain undecided on the value of meeting management in large businesses, investors need to keep all options open. Rather than depend on investment banks to provide access to their chosen clients, fund managers must engage more actively with the investor relations teams to directly source the information required. Access to information has never been more readily accessible. Most companies provide timely webcasts and detailed presentations on trading and strategy. Investors are unlikely to gain any further insights from a meeting. Analysts and fund managers should have the skills to analyse in detail the prospects for any investment and a suitable understanding of the risks.

It can never be acceptable to outsource this responsibility to sell-side analysts, who frequently have conflicting objectives. Increasing barriers to new fund management entrants and further concentration of the sell-side are unlikely to lead to greater transparency and lower costs for investors. The application of MiFID II has significant costs to business, both from introducing new measuring and reporting systems and in management time. While smaller businesses are frequently more nimble and responsive to client needs, they typically suffer more from the bureaucratic burden of new legislation. The response from fund managers must be to increase the quality and quantity of their own research and work more closely with corporates to enable a greater understanding of the industry and businesses where they invest client funds.

About Graham Campbell, ASIP,
Chief Executive Officer, Saracen 

Mark Having joined Saracen in 2011 as a major shareholder, Graham is CEO, as well as Co-Manager of the TB Saracen Global Income and Growth Fund with David Keir. His previous roles included directorship at both Edinburgh Partners and Edinburgh Fund Managers, as well as Global Head of Retail Funds at SWIP, and  a spell with National Mutual & General Accident. Graham was a former Commonwealth medallist at Judo, and remains actively involved in the sport as a 6th Dan.