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The use of dealing commission to pay for investment research may be news to most FT Money readers. The Financial Conduct Authority reckoned £1.5bn of investors’ money — over and above charges that savers had agreed to pay to investment managers — was spent on investment research in this way by UK investment managers in 2012 alone. Yet where is this expenditure disclosed to investors?
Nowhere. So what is it? Basically, “dealing commission” is a payment made to brokers when shares are bought or sold by an investment manager. Part of this dealing commission covers the cost of the execution of the trade. The rest, which can often be more than half the total, is used by brokers to provide “investment research” back to the investment manager.
The FCA estimated that investment managers spent £3bn in clients’ money on dealing commissions in 2012 and that those same investment managers got £1.5bn of that money kicked back to them in the form of “investment research”.
The vast majority of this research is provided by investment banks with a tiny part provided by independent research houses. Most of it comes in the form of buy/sell/hold notes, mostly delivered by email. It may have cost investors £1.5bn, but is commonly acknowledged that much of it is valueless and even some of the research providers will admit, off the record, that 90 per cent of it is never read by anybody.
If that sounds weird, fasten your seatbelt.
The FCA also estimated that £500m of the £1.5bn was spent on “corporate access”. The ability to meet company management is highly prized by most investment managers and for many of them, investment banks are the gatekeepers. Bizarre as it may sound, investment banks used client money spent on research to allow investment managers to get to the head of the queue and meet company management.
The FCA has now banned this from the list of permissible kickbacks from dealing commissions. Now, it is either charged direct to investment managers at a much lower rate, or provided free and referred to as “service”. Of course, those who spend the most on execution still expect to be top of the list for access.
In addition, brokers don’t set prices for their research. They just ask investment managers to pay in arrears a “fair share” of the manager’s total research spend. That total was often linked to the level of trading. A busy trading period generated more money spent on research but did not generate more or better research. Fortunately, FCA attention has led to considerable improvement in this area.
Although many investment managers bend over backwards to manage this system with integrity, the system creates irreconcilable conflicts of interest and cross-subsidy — both for investment managers and brokers. It came about at a time when broker commissions were set by a fixed tariff. As a result, brokers couldn’t compete on price and so they started to produce research to create an edge.
Fixed commissions were abolished 30 years ago at the time of Big Bang. It is now high time that this research practice was abolished too. It’s a practice you can’t explain to anybody outside investment management or investment banking without them immediately recognising the problems.
The only rational solution is for investment managers to use their own money to pay for research and if necessary, corporate access that they believe can help them do a better job for their clients. They would include the costs within their management charges, just as they already pay for their own analysts who provide internal research resource.
This would remove the risk of cross-subsidy between clients and the inherent conflict of interest that could tempt an investment manager to spend client money carelessly on research because it could give them privileges when it comes to corporate access or preference in allocations for attractive new flotations.
Only research that has real value would thrive. The reality is that while this might cause short-term dislocation, there would be a market solution. And it would be better for clients and better for investment managers themselves in the long run.
It would also be better for the economy. One of the investment management industry’s key roles is to direct the nation’s savings in the most productive way. And yet here we are, in the industry’s own backyard, with a system that demonstrably doesn’t meet that objective, with massive overproduction of unread research that has no economic value.
To deserve trust and rebuild confidence, financial services should be breaking down and eliminating cross subsidies and conflicts of interest, not fighting tooth and nail to defend them. When research was threatened, first by the FCA and then by Europe, the Treasury and European Commission saw intense lobbying such as they had never seen before, both from investment managers and investment banks.
They claim that if investment managers are forced to spend their own money on research, research and liquidity will collapse, barriers to entry for small investment managers will rise and (a real political hot potato) that small and medium-sized companies will be deprived of capital. These are false assertions claiming to be facts.
But for the real grounds for opposition, follow the money. According to industry estimates, the £1.5bn that the FCA estimated was spent on research in 2012 would probably have been equivalent to over a third of the UK investment management industry’s profit that year. And follow the “corporate access” and IPO allocations for which many managers depend on the brokers.
There are many excellent investment management firms who do the best job they possibly can in working with this inherently flawed model in the best interests of their clients.
One shining light is Baillie Gifford, which is the first big UK institution to have announced a move to execution-only rates for all their brokers from this year — meaning they are now taking the cost of corporate access and research on to their own profit and loss, not making clients pay for it as an added cost. Others will surely follow.
This model needs breaking and the global industry and global regulators should work together to evolve to a new model where investment managers pay for all the operational costs of running a fund from a simple management charge. This is only what most of their customers would assume was the case today. A conventional market where investment managers pay only for things they want at a price they think is reasonable would be created to replace this through-the-looking-glass system that we have today.
The investment management industry needs to address this and other key issues if it is to be prosperous and sustainable. And the situation won’t change overnight. But if honest engagement with the customer becomes the watchword then eventually we can look forward to an industry fully serving the interests of customers and society.