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Unbundling, transparency and research payments

Is it now time for investment management to come clean and quickly move beyond the regulatory forbearance that is now inevitably coming.

There is a more important reason for fund management to get this issue addressed themselves. The point the regulator makes is a fair one. However, the air of impropriety that surrounds this subject, whether or not you believe commissions are legitimate will not now leave and is another reason for investors to question the probity of the industry.

With auto enrolment and pension reform now in full flight, the role that transparency will play cannot be understated. A new class of investors will not be compelled to move away from the default option otherwise.

The evidence of the drag to investors from brokerage and research commission payments does not present an alarming story of excess. For a decade there has been a move away from entertainment based broking generally and most fund firms have strong rules against inducement.

Fund managers should look to leapfrog the on-going charge (OCF) and total expense ratio (TER) regime. The new model will see the fund being charged once only, not being treated like a bank teller machine for expenses. With no hidden expenses being carried outside such a charge, the management fee will become the final balance. It is unlikely the HMRC will wish to receive their stamp duty differently, so that will remain an expense for UK equity investors. Once the fund is charged only once, transparency will radically alter. If the residual balance after all expenses are paid is the management fee, it will encourage a less laissez-faire attitude by fund managers.

It is also likely that the execution commission costs are substantially dwarfed by the unseen costs of trading and the impact that dark pools and high frequency trading (HFT) are having today. This may be the next smoking gun for the industry. The complexity and profitability of dark pools and high frequency trading confirms something is wrong. Is there something amiss when an order routed by the fund manager to their broker is routed by that broker to a dark pool where they pay nothing and may earn a rebate; are fund managers then just providing liquidity and dumb money for the HFT’s to profit from. The act of creating liquidity for the HFT market, at the expense of the old fashion fund manager is not profitless, otherwise there would not be an HFT market.

The question fund managers must be asking is whether their trading is source of liquidity for HFT’s and alike or the other way around. This question can be resolved with in-depth analysis of execution records. A good trading desk should not be self-reporting and the expertise is unlikely to be compliance based. There is potentially real gains to be made in a performance context from this analysis if it can lead to improved execution.

Fund management must also make strides to improve how they value investment research from third-parties, otherwise it will suffer under the suspicion of inducement. It is a cost of sales for the production of investment. New technology will make it easier to evidence the fact, though the real strides will come from destroying the “10%” myth that is the mantra of those wanting to destroy investment research. The fact is that statistically 10 fund managers reading a different piece of research on the same stock would create the 10% myth, when in fact 100% of the research was consumed.

It should not bother investors or the regulator how much fund managers spend on research if it is that the cost is unpacked from the execution. There is not an operational restriction other than an administrative implementation to paying hard dollars. Putting in place the appropriate solution now will permanently resolve this issue and give those managers a competitive advantage with clients.


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