Though it is hard to imagine now, securities markets used to get by without analysts. Back in the 1960s and 1970s, equity fund managers focused on the domestic markets and did their own research, while bond markets were dominated by national government debt and most buyers were long-term investing institutions who felt they did not need any outside help. This meant there was little demand for either credit research, or the macro economic forecasters who are so widespread today. Investment analysts only really came into their own from the 1980s onwards, when markets became international, benchmarks were developed and investment performance came under much more scrutiny.
Today there are hundreds of investment analysts in the City, but perhaps not for very much longer. The primary aim of the EU’s MiFID II is to encourage equity investment and the development of capital markets by making them more transparent and less riven by conflicts of interest. As part of this process it requires that fund managers pay openly for any investment research that they receive instead of ‘rewarding’ the analyst indirectly by placing trades through his or her firm – the cost of which has been picked up by the clients, not the asset manager.
It is not rocket science to understand that fund managers will be a lot more careful spending money when it is their own rather than someone else’s. They will be choosy about the research they take and more willing to haggle on the price. They need to be too, because though fund management is a profitable business globally, active management fees are under pressure as more and more funds are switched to passive strategies. In this environment, research costs could hit asset managers hard. It has been estimated that if they paid the current implied cost of research it would cut their profitability in half.
According to Capital Access Group, an independent research provider, there are about 1,200 analysts producing research in the main market in the City. It costs their firms around £200m to employ them. Bloomberg estimates that around £1.1bn is paid in equity commissions in London. If one assumes that an average share trade attracts a commission of five basis points, and a quarter of that is the implied cost of research, then that would generate an income for analysts of £250–280m. This would easily cover their costs.
The number of analysts will halve in the first 12 months after MiFID ll becomes operationalBut it is not that simple for two reasons. As Capital Access Group points out, the industry is very concentrated. On the buy-side, the top 20 asset management firms control two-thirds of UK equities, and while there are 180 securities houses, the top 20 of these account for 80% of the trading, getting the lion’s share of commissions. However, this numerically small group employs only 20% of the analysts.
What you can conclude from this is that a few analysts do very well for their firms, but the majority struggle to cover their costs. Add in the fact that their attentions are not evenly spread – there are 25 analysts covering Vodafone and Unilever, but almost no one covering small companies – and you see that conditions are ripe for a cull. With this in mind, Capital Access Group forecasts that the number of analysts will halve in the first 12 months after MiFID ll becomes operational in January 2018, and will drop to perhaps a third of current levels the year after.
There will be structural changes too. Currently, most fund managers have some in-house research capability, and some, like Fidelity, have a considerable resource. It may well be that when asset managers see how much they should pay to get access to the best ideas from star analysts in the leading investment banks, that they decide it makes more sense to employ more of these people directly. MiFID II might, in time, lead to the rebirth of buy-side research – though it should be said that there is as yet very little sign of serious moves in this direction.
Rather, what we see now are the big investment banks pricing aggressively in order to sign up clients and maintain market share. This will put obvious pressure on the analysts in smaller securities houses, but there is also a risk of collateral damage to independent investment houses because such tactics also undercut their pricing. Ironically, these are exactly the kind of firms MiFID ll seeks to encourage; they are, by definition, impartial and unconflicted and live or die by the quality of their work.
Running such businesses should be easier when they can be paid directly, rather than indirectly, for the ideas they produce, but we are certainly not there yet. Even the optimists tend to agree with the verdict of a report produced by the Centre for the Study of Financial Innovation which suggests that it could be two or three years before things settle down. It is confident that, in time, a more transparent and better system will emerge – but it is equally in no doubt that not everyone will make it to this promised land.
Seen a blog, news story or discussion online that you think might interest CISI members? Email jake.matthews@wardour.co.uk.