I was an equity research analyst for ten years. I loved the work – meeting people, arguing with them and writing about it. I am also a big believer in the idea that there is value in research, it makes for better investment decisions. That all being said, I will be the first to admit that the Equity Research industry is a complete mess. I have written about this in the past on multiple occasions. In the past few days, there have been some interesting developments on this front. And while I never thought I would be writing this, the biggest news came from European policy people.
In June, the EU’s European Commission released proposed legislation regulating the financial services industry. This is known as MiFID II, a sequel to MiFID which stands for Markets in Financial Instruments Directive. Among other items, MiFID II proposed “unbundling” research from brokerage commissions. Let’s pause for a moment, this is as deep as we need to go into EU esoterica. The way it works today is that brokers provide research to all their clients. These clients are fund managers, the people managing our retirement plans. The brokers provide this research with an implicit understanding that those clients will then trade with the broker, and pay commissions on those trades. Put simply, research is the loss leader the brokers use to market their services, but they collect revenue from the commission trades. The problem, as I noted in all those earlier posts, is that trading commission rates are rapidly declining. Trading a stock is one of the most commoditized digital products imaginable.
So the EC thought that brokers should de-couple these two elements. Fund managers should pay one fee for trading and one for research. This is a ground-shaking change. The regulators thought that charging for research would allow for better competition, and that without the ‘inducement’ of research, the fund managers would seek out the lowest priced trading commissions they can find. In theory, this would be to the benefit of the funds’ own clients – you and me and everyone else who owns a mutual fund, hedge fund share or a pension.
The problem is that suddenly asking someone to pay for something which has been free for decades is highly unsettling to the people providing it.
Don’t Hate the Player, Hate the Game
Let me be more blunt – 90% of the research content that is coming out today is worthless. It is regurgitated press releases and me-too, Monday-morning quarterback. I am not saying that 90% of analysts are bad, but the market has gotten so disjointed that even the best analysts have to put out a lot of marginal content. There is no doubt in my mind that if fund managers are forced to pay for research, they will pay for very little. And that means the brokers are going to have to radically reduce their analyst teams. To make matters worse, the people running research at many of the brokerage houses are not the top-tier of managers at their respective institutions. I have no faith that they will be able to pick the right people to keep and the right people to cut.
The good news is that today, the EC seems to have reversed itself. Instead of forcing unbundling, they may settle for brokers merely enumerating the costs of research. It sounds like brokers would just have to submit an invoice breaking down how much of their clients’ fees go to trading and how much to research. The clients would still pay the same amount, but they would now be able to see clearly how much research is costs.
I see all of this as a mixed blessing. The financial research market needs to change. It is the height of folly to think that somehow research is going to be the one form of content that is not totally ‘disrupted’ by the Internet. If the Europeans had actually gone through with MiFID II’s proposals it would have caused a giant bonfire of research shops, then a few years from now something better (or at least more commercial) would rise out of the ashes. The new proposal looks likely to just push the debate out for a few more years.
Still, I think brokers and research analysts need to be thinking about how to change models. This debate is not going away. The whole industry needs to think about how much is research actually worth.
Apparently, one of the reasons the EC backed down was that many small fund managers complained that they need research, and the new rules would limit their access to that content. That pretty clearly argues in favor of the value of research. On the other hand, if research is so valuable, why are those funds not willing to pay for it?
The root of the problem is that there is clearly value in research, but no one knows what the price of that research should be.