It is agreed that the pricing of investment research at the moment is a hot topic and something that is changing as dramatically as the British weather! Yet, the equally important question that usually gets buried is, who is paying for the research? Is the pricing based on research evaluation?
While some investment managers are absorbing the cost of external research, amounting to around 1-2 basis points, the others are willing to pass on the costs to their investors which surprisingly is seen around 7-12 basis points according to Quinlan & Associates.
This completely lopsided spending pattern needs to be looked at from the perspective of investment research being the driver of alpha for any possible justification.
How is MiFID II impacting the research pricing?
For the uninitiated, MiFID II has brought in several expected and unexpected changes in the investment research landscape. The most prominent of those changes is its impact on the research pricing and in turn the party who pays for the research. While the regulation demands separation of research and execution, it does not throw enough light on the pricing models for research. This has resulted in ad-hoc pricing models and price wars which are threatening the boutique and independent research providers.
Why does it matter who pays for the research?
If an investment manager chooses to absorb the cost of the research, it is seen that they usually squeeze the overall budget for research to maintain profitability. It is too early to tell whether that rationale is justified and if it will not have any detrimental impact on the performance of investment portfolios. Alternatively, when the research costs are passed on to the investor, it could lead to ballooning of the total expense ratios in this low fee environment. The compounding effects such higher expenses can significantly impact the net return over a long period.
How can you justify the research spend?
While the overall price of research is expected to come down under MiFID II, we should not forget the fact that beyond the cost of research lies the impact of research on investment portfolios. Spend on research that truly drives alpha is justifiable irrespective of whetherit is absorbed in-house or passed on to the investors. However, it is not easy to identify the research that produces alpha consistently, i.e. value the research in a forward-looking fashion.
We believe that broadly there are two crucial considerations to ensure the research spend is justified and well informed.
COMPLETENESS OF RESEARCH COVERAGE
Matching the research coverage requirements with a list of providers is much harder than it sounds. Especially transitioning from pre-MiFID II to post MiFID II research consumption, it means reviewing the existing relationships and coming up with alternatives to justify. It gets further confounded when you bring the “bundled packages” or “portal access” offered by bulge bracket banks into the mix.
A well laid out coverage requirements including the small niche pockets (small caps, emerging markets etc.) should be matched intelligently with all possible providers based on their coverage (portal access or otherwise), expertise and past history which is very hard to collect consistently across all providers.
ALPHA GENERATION CAPABILITIES OF INDIVIDUAL RESEARCH PROVIDERS
Choosing the research with a track record of generating alpha is the key to beat the markets. There is strength in numbers! However, it is very difficult to get access to the track record of the research providers and more over, until and unless the track record is available for all possible research providers, it cannot be used as a measure to choose the research providers.
Even with access to the past recommendations, it is time consuming and expensive to do the back-testing of all possible providers.
Through its proprietary evaluation methodologies, Invisage (previously Parity One) does a thorough quantitative and qualitative analysis of the performance of research for all research providers. In addition, it helps understand the alpha generating capabilities vis-a-vis the investment strategy to provide clarity on the underlying parameters that could be driving or stalling the performance.