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OPINION

The trouble with broker notes

The trouble with broker notes
August 20, 2015
The trouble with broker notes

The good news is that investors, who have been funding such research for years, should get a better deal when the revised Markets in Financial Instruments Directive (Mifid II) is implemented in January 2017. The bad news is that this will make the economic incentives facing stockbrokers even less likely to produce independent equity analysis.

The current system is a barely defensible fudge that emerged in the wake of a 2001 report to the UK Treasury by Paul Myners, then the recently retired chairman of fund management house Gartmore. Mr (now Lord) Myners shocked his former colleagues with the commonsense recommendation that broker commissions for research and execution services be covered by fund managers' regular management fees, rather than being charged to investors on top. Among other benefits, this would remove the "inefficiencies and complexities" associated with the practice of 'soft commission', whereby research and other services were 'bundled' together with trading fees.

The light-touch Financial Services Authority (FSA), as it then was, shied away from the core point that investors should not be charged extra for costs over which they exercised no control. But it did pick up on the issue of 'bundling', arguing that it routed trades inefficiently and encouraged the overconsumption of research. The regulator's solution was that fund managers should rebate the cost of sellside research back to investors.

Naturally, the fund industry, sniffing a threat to its margins, protested. The FSA eventually backed down in favour of a mid-ground called 'commission sharing agreements', which still exist. They require brokers to retain a portion of the commissions they charge to fund managers, nominally for execution services, and then pass them on to potentially independent research providers based on fund manager votes. Developed as a sticking plaster, this crude unbundling mechanism has evolved into the norm.

But the system will change under Mifid II. The European Securities and Markets Authority - the EU regulator drawing up the new rules - initially proposed an outright ban on fund managers paying for sellside research out of client funds. But last December it softened its stance by suggesting that a separate research budget would be allowed, if agreed with the client. Much will depend on how the reformed Financial Conduct Authority implements Mifid II. A consultation paper is expected in December.

Whatever the rules end up being, the direction of travel is clear. Given the downward pressure on management fees as passive strategies take greater market share, fund managers will become much more discerning in their consumption of research if they have to pay for it out of their own cost structure. Richard Balarkas, a financial services consultant, thinks spending on equity research will fall by at least 30 per cent, and possibly by as much as 80 per cent.

Even stockbrokers seem to accept that the old business model is out of date. "There aren't many sectors that, like fund management, pass raw material costs on to the end client," admits Lorna Tilbian, executive director and head of media at Numis Corporation.

Ms Tilbian says corporate fees - those charged by brokers to listed companies for raising finance, advising on M&A and just everyday hand-holding - will have to rise to replace commissions. To put this in context, during the six months to March Numis earned £14.4m in commissions from institutional investors ("against a background of increasingly challenging regulatory proposals"), £25.9m in corporate deal income and £4.4m in corporate retainers.

The current regime has engineered a gravy train of excessive charges for barely read research, fully funded by the investor. Ms Tilbian's alternative - stockbrokers paid by companies rather than investors - would reduce the overconsumption problem, but it is far from ideal. For a start, investors will end up footing the bill anyway in the form of lower corporate profits. And, more importantly, it means investment research will increasingly reflect the interests of companies rather than those of investors. If those buy/hold/sell recommendations are already more or less worthless, tying them to ever heftier corporate retainers will make them absolutely worthless.