Written by 12:03 am EU Investment

Fund managers question ‘ineffectual’ MiFID II unbundling review: ‘Everyone has moved on’

The government’s review of investment research rules is unlikely to reverse the reduction in output triggered by MiFID II, according to City insiders.

Chancellor Jeremy Hunt announced a review of “the provision of investment research in the UK, including the effects of the EU’s MiFID unbundling rules” on 9 December, as part of a package of post-Brexit deregulation dubbed the Edinburgh Reforms.

But even if the government scrapped the current rules on payment for research, most asset managers would not revert to the old system which supported higher spending, sceptics say.

“MiFID II is well in the rear-view mirror now and everyone has moved on. It is a bit late to imagine that reversing or modifying any of this would help anyone,” said Colin McLean, chief investment officer of Edinburgh-based SVM Asset Management.

Under MiFID II, which came into force at the start of 2018, asset managers were no longer allowed to “bundle” payment for research with the trading commissions charged to their funds. Instead, most opted to pay directly out of their own profits.

As many critics had predicted, this led to a big fall in spending on third party research and a reduction in the amount of coverage, particularly of smaller companies.

Those lobbying for the scrapping of the MiFID rules say they have reduced liquidity in smaller company shares, increased the cost of capital, and made it less attractive for businesses to go public.

The rules have also hurt UK asset managers relative to their rivals based in the US, where the old commission-based payment system has been retained.

“European asset managers are at a huge disadvantage,” said Neil Scarth, an expert on investment research at Frost Consulting.

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Campaigners for scrapping the rules convinced Liz Truss, the former prime minister, it would be good for the City and could be portrayed as a Brexit dividend, even though the rules were originally championed by the UK’s Financial Conduct Authority.

But Peter Sleep, a senior portfolio manager at Seven Investment Management, said that asset managers have all already adjusted to MiFID II, which, as regulators hoped, has reduced the amount of low-quality research.

“We have found room in our budget to pay for research that we value and vastly reduced the number of unread emails we receive from non-core brokers,” said Sleep.

He added that the problem with research on small companies is that it was always uneconomic “as they generated so little brokerage”.

Mike Carrodus, chief executive of research consultancy Substantive Research, said that the lack of small company research reflects the dearth of investor interest in small companies, not the change in the method of payment.

In response to concerns about the impact on small companies, the FCA recently relaxed the rules to allow bundled payment for research on companies with a market value of less than £200m. The EU has just proposed going much further with an exemption for companies worth up to €10bn.

But Carrodus said that changing the payment rules would make little difference. However keen asset managers are, end investors would simply refuse to go back to the old system and pay more.

“It is so tempting because it sounds so sensible but it will be ineffectual,” he said.

One thing regulators could do to increase the amount and diversity of research would be to stop the big investment banks undercharging and putting independent research firms out of business, Carrodus said.

But Scarth believes that reform of the rules could be effective in reducing the cyclicality caused by asset managers paying cash for research, which puts intense pressure on research spending when asset managers’ profits are falling as they are now.

With asset manager profits under pressure, many will be tempted to back reforms if it means not having shoulder the full cost of investment research, Scarth said.

“There is going to be an animated discussion about this,” he added.

Scarth added that investors need to spend more on research because of the increasing scrutiny on environmental, social and governance issues.

But while asset managers might hope their profits would be boosted by pushing payment for research back to the funds, some observers remain sceptical.

“I suspect [asset owners] would demand that all of the benefit was passed on in lower fees,” said a portfolio manager at a UK-based asset manager. “This alone probably means asset managers aren’t going to rush to push for the reversal of unbundling.”

To contact the authors of this story with feedback or news, email David Wighton and David Ricketts

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