Part 2: How to value research
Read Part 1
Determining the exact pricing of research is a daunting challenge, but it can also provide a refreshing view of the real worth of research material and services to consumers. How much granularity is required? How does the pricing process impact across the product range? How can the model be incorporated globally when direct payments in the U.S., for example, are still restricted to those brokers who are authorized to provide advisory services?
In the past, research costs were primarily associated with the equity order flow. However, research is relevant across the multiasset environment. The financial services industry has persistently lobbied regulators for macroeconomic or currency research to be handled as a minor, nonmonetary inducement. The revised delegated acts, published in April 2016, state that the description of research is applicable across all financial instruments (or other assets or issuers), thus creating a requirement for the research providers to consider pricing at individual asset class level, as well.
For a research service provider, if its consumers are only focused on one asset class, it might not be an appropriate offering if the provider were to give one price for the full range of research. In contrast, others in the industry may offer a more granular approach, which could be more attractive (being relatively cheaper) to consumers. This a la carte-style offering is complex and could also be a costly implementation for the sell-side research providers to support, resulting in complexities for the logistics of pricing, usage tracking and financial accounting.
Despite the challenges, this revised distribution model brings innovation into the financial services industry in multiple ways. New pricing models and service offerings can be considered to support future-proofing of market share while remaining segregated from the execution offerings. This means fresh entrants can enter the marketplace: specialist or niche research houses without execution services that can receive direct payments from the investment firms. It also encourages broker reviews to support the consumer with tools to better manage their services.
Research is no longer a free inducement, and the resulting increases in service levels can now be measured and used to govern decisions on investments in research in areas including: removing underperformers, increasing service quality and buying power, building positive perceptions of a professional buy side and guiding the sell side by providing strategically important input. Overall, the new approach contributes to ensuring that they receive their money’s worth while acting in the best interests of their investment strategies and their clients.
Separating charges can be more challenging to apply proportionately at a transactional level if the investment firm offers services for individual client transactions – for example, a multiasset environment – including execution-only, advisory or discretionary business. The disclosure requirements for transactions require an explicit research cost to be evident, clearly separate from execution and available for each relevant client. Therefore, to make the approach fair, all orders would need to be handled through a consistently priced model, applying no differentiation to the individual client costs for research. There is also a requirement that all clients of a service offering could expect to see a charge for research cost elements of those services.
This raises questions. Would this charge be applicable to all execution-only clients? If the costs of the research applied only to certain asset types, e.g., equity trades, how could execution-only clients who only trade other asset types be charged for research? For a client-funded research payment account, the budget for research needs to be predetermined and cannot exceed the value initially reported. This is difficult to achieve if a firm tries to determine levels of client activities in advance of their occurrence. Errors in forecasting transactional activity may result in a significant budget rebate or an effective carryover, making repayments difficult to manage. There is also the challenge of justifying cost proportionality back to individual client portfolios, in cases where these client accounts might well have been closed at the end of the budgeting period.
Given there are so many disclosure consequences applied to research payment accounts, why are they still a popular solution – backed by extensive lobbying from the industry – to retain some form of transaction-related charging structure?
Most likely, this is because the differences in disclosure requirements and payment handling, based on whether the firm is running a fund rather than a wealth management or retail client direct investment service. Payments for research (and execution) at a transactional level can be managed effectively at the fund level while retaining fair proportionality of charges across all clients who are invested in the fund. The net asset value (NAV) of the fund remains the same for all client investors within the same share class. Therefore, payments or rebates can be made to settle the research costs, and this can be clearly disclosed during periodic reporting. As a result, we will see many companies continue with the research payment account option, although it is hard to deliver on disclosure requirements within a retail investor service model, such as stockbroking or wealth management.
The third and final part of this three-part series looks at the challenge of ongoing value measurement.
Natasha Leigh Giles is a Managing Principal at Capco Switzerland with almost two decades of experience in the financial industry. Having started on the trading floor in wealth management, she now leads business and technology change programmes, from definition to implementation, across front, middle and back office.
The content and opinions posted on this blog and any corresponding comments are the personal opinions of the original authors, not those of Capco.