Paying for research:  the smaller asset manager's dilemma

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Since BlackRock announced in September that it would pay for research from its own resources, an avalanche of big names has followed suit, catching smaller asset managers between a rock and a hard place.

Paying via P&L will hit the bottom line of smaller fund managers the hardest, and maybe put them at a competitive disadvantage. Financing research through an RPA misses out on PR kudos at best and could cause real damage at worst. RPAs require intensive administration and are a potential drain on time and money. 

With less than 30 working days to when MiFID II goes live, a new study has put this payment dilemma into perspective.

The survey by the CFA Institute found a clear correlation between assets under management (AUM) and a willingness to absorb research costs, as well as greater uncertainty amongst smaller firms about how they would pay. Some 67% of respondents at companies with AUM of more than €250B expected their firm to carry the cost, compared to 42% from firms with less than €1B AUM.

The degree of uncertainty was also greater among smaller firms, with 25% saying they are not sure whether the cost would be absorbed or passed on to clients, compared to the 21% overall who are still unsure how their firm will pay for research from January.

The CFA’s report, MiFID II: A New Paradigm for Investment Research, covered 330 firms in 28 European countries. Significantly, it found 22% of smaller firms expected clients to pay for research while only 9% of the largest firms were passing on costs to clients. With the above in mind, this article will take a closer look at the research payment account (RPA).

RPA Mechanics, Obligations and Usage

To comply with MiFID II, asset managers may fund an RPA through either a direct charge (the accounting method) or a fee for research can be collected alongside execution fees (the transactional method). The latter allows firms to continue using a form of Commission Sharing Agreement (CSA), a soft dollar arrangement popular in Europe, which sees a proportion of bundled charges fed through to the research provider via the executing broker.

The use of RPAs has many obligations, as detailed in Article 13 of the MiFID II delegated directive. These include the need to periodically set and review a budget, regularly assess the quality of research, agree research charges with clients before the receipt of any service, provide detailed audit trails of payments, and a written research policy showing how costs are fairly allocated and how research has benefited clients’ portfolios.    

Broadly speaking, those managers comfortable using a CSA will pick the RPA transactional model, while those new to the process are likely to choose the accounting approach. In the UK, the majority of hedge funds have chosen to work with RPAs, while fund managers are trending towards P&L. In Europe, RPAs may be more popular given the historical prevalence of CSAs.          

FCA Guidance:  Sweeps, Virtual Accounts, Netting and Admin Payments

The FCA’s final policy statement on MiFID II implementation (PS17/14) offered some in-depth guidance on RPAs.

Once a charge is deducted from a client into an RPA, those monies belong to the investment firm. Where the firm is using a third party to administer those funds, it should ensure the transfer of research charges into the RPA is made within 30 calendar days of the transaction. This approach “provides certainty for firms as to what our minimum expectations are, which aligns with current industry good practice where firms are using CSAs,” the FCA said in July.

The FCA considered views on whether a single RPA should be required per budget or if a ‘virtual’ RPA, that gives a consolidated view of funds held in multiple underlying RPAs with different brokers, could be acceptable. While it continues to view a single consolidated RPA as more efficient, it does not intend to prevent a virtual RPA with multiple underlying RPAs provided that each individual RPA is still adequately protected.

Firms should have the ability to implement a combination of RPA and P&L methods to pay for external research, as such flexibility may be helpful for firms managing different types of assets (e.g. equities or commodities). However, the FCA said payment netting (aggregation of RPA and P&L streams) is not consistent with MiFID II requirements as it had the potential to reduce both the transparency and oversight applied by firms, and could even result in the continuation of fully bundled execution and research fees.

Where a firm cannot isolate the research element of a broader service, the FCA would expect it to bear such costs from its own resources. It follows that an investment firm should pay a discrete charge for RPA administration from the firm’s own resources. The regulator added that a broker does not need to charge for facilitating research fees and temporarily holding these before transferring them into an RPA, but only needs to identify a separate charge if it provides the RPA itself (which is permitted under MiFID II).

RPA Resources and Best Practice

With MiFID looming, a trade body group recently published a template aimed at simplifying the research payment process for asset managers. The Investment Association, the Alternative Investment Management Association and the Association for Financial Markets in Europe will offer the template, known as the Research Charge Collection Agreement (RCCA), to members, enabling them to fill in the details and collect charges from clients in a compliant manner.

Similarly, a group of research service providers launched the RPA Code of Conduct earlier this year, following an extensive consultation process involving over 50 asset management firms and representatives from the pension fund, wealth management, and retail investment communities. The RPA Code focuses on issues such as the scope of the RPA and its placement within the organization, research budgets & valuation, payments and access & distribution.

RPA and P&L: Where the two roads meet

While asset managers using their own resources or client money approach payment from two different directions, there is at least one common theme – the need to value research and interactions.

Those paying via P&L need to ensure that resources are being allocated in the best interests of the client and show the CFO and Board of Directors that money is being spent wisely on the best, alpha-producing research. A vigorous valuation framework also means poorly performing providers can be swapped out for trials of more promising ones. 

When using client money via an RPA to buy research, a sophisticated evaluation system can help meet many of the new obligations, not least the need to regularly assess the quality of research and provide evidence on how the research selected has benefited clients’ portfolios. Such a system also plays a key part in creating an audit trail.    

Whichever payment method is chosen, asset managers need to ensure that they have a robust procurement process in place. Research should be subject to the same rigor as any other business purchase, and meaningful evaluation should be at its heart.