Dealing commissions; do clients get value for their money?

In one key area of asset management, the UK regulator is aiming for global leadership. The Financial Conduct Authority has ambitions to drive the EU debate on dealing commissions, and establish London as an investor-focused low cost centre. The first step is its current consultation on dealing commissions, which should raise standards and give retail investors the information that institutional clients already demand.

The FCA review could lead to radical change for the UK investment industry. The concept of bundling company research within dealing commissions is under scrutiny, with a ban on paying for research via client commissions a possibility. Even if commissions survive this review, significant change is likely. Getting the balance right could result in a more competitive UK fund management industry with demonstrable value for clients. But any misjudgement could kill off many smaller fund managers and brokerages, reducing research and choice.

Dealing commissions are an added charge on most equity trades, but go beyond execution costs alone. The UK Regulator has highlighted some abuses of the current regime. Paying for market data services, use of commission for corporate access or primary research, and high portfolio turnover all appear to contravene the FCA conduct of business standards. However, some asset managers believe that the existing rules are tough enough to allow the FCA to stop these abuses, and indeed there is no suggestion that these are commonplace. Yet, the FCA would like more exacting standards, and is also keen to see a competitive UK industry that clearly services client interests. In an environment where transparency on investment costs is improving, commissions remains one of the murkier areas.

Commissions paid by UK investment managers total £3bn a year, and the FCA estimates half of this represents research services, with an additional one-sixth paying for corporate access. Any change to current practice will impact both the buy-side and sell-side. For many asset managers, commissions bear a meaningful portion of their costs. It is possible to operate a commission sharing arrangement to pay for some services on a “soft” basis, but this requires prior notification to clients, and can only operate with their agreement. There is not yet an active market in independent research services.

That the commissions are client money is not in dispute. Since 2006, investment managers have only been permitted to use commissions for a restricted range of services. These are confined to execution-related and research services, with research precisely defined. Research paid with commission must be original and meet standards of rigour, analysis and meaningful conclusions. Anything that does not match these exacting standards would represent a misappropriation of client money. That includes most market data services and corporate access.

Most suspect there is simply too much research overall, with some of questionable value. Large companies can be followed by as many as 30 analysts, but with much of this simply maintenance research. But, prior to this FCA initiative, there was little sign that the industry would identify and cut out the poor research. Even if bundled dealing commission survives, the review will force a rigorous evaluation, and force out low quality research. Asset managers might take a tougher line if they were spending their own money.

Last year, the Regulator also warned on management of conflicts of interest. The use of commissions for research must clearly offer value, but should also be correctly apportioned between clients. Asset management firms need robust processes to evaluate research and make sure that the payment of this through bundled commissions ends up with each client contributing fairly. The problem is that investment managers, in trying to achieve best execution, may find it convenient to aggregate trades. This could mean, say, a UK equity client dealing via a broker rated for global macro research. It is not just the conflict between managers and clients that creates the problem, but necessity for fair allocation of research costs across clients.

Many institutional clients demand IMA Level 2 Commissions Disclosure – a practice that sheds light on research and execution. But, unfortunately not all clients – and certainly most retail investors – do not see this. It would be good practice to make more public disclosure of the extent to which an asset manager uses commission sharing arrangements. Similarly, some institutional clients will focus on portfolio turnover rates that generate bundled commissions, but this scrutiny is not readily available to investors in most unit trusts. Many asset managers do recognise the inherent conflict in being able to increase portfolio turnover to generate research payments. The typical solution is to apply some internal control. However, clients – both retail and institutional – may require greater transparency and accountability on this. Of course, managers are measured ultimately on net performance after costs, but this may not be sufficient sanction against portfolio churning.

The FCA believes that the onus should be on asset managers to demonstrate that criteria are being met for good research. It may be that firms could implement more benchmarking against the value of research that they would buy with their own money. There is a case for fund managers demonstrating that they have gone through this pricing process, and asking a chief executive to sign off regularly that the exercise has been thoroughly conducted. At present many managers and clients do not operate a full breakdown of bundled research, determining execution and research elements. This should be demanded as an essential part of discharging conflicts of interest management.

The amendments to the Regulator’s conduct of business standards might appear modest, but the threat of a ban on commissions for research hangs over the industry. Some research might survive abolition, with trading on a net basis and hard cash payments from fund managers for what research they need. The industry also needs more explicit pricing from the sell-side. Many investment banks provide “research” as a loss leader, aiming to attract new institutional or corporate clients, or to win IPOs. The FCA should recognise that not all that investment banks and stockbrokers offer is paid for by commissions. Much of what is published is not independent research but marketing commentary. A regulatory focus on the buy-side, without addressing potential conflicts and pricing issues in the sell-side, might not achieve its aims.

Forward looking reform is necessary, but the danger is the UK standards could become detached from international peers – there is little sign of the US SEC taking much interest in the topic. The FCA should ensure that change is not disproportionate, and genuinely improves competitiveness and client service.

A version of this article was published as an Op-Ed in Financial News on January 20 2014.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. I have no business relationship with any company mentioned in this article. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

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