US 2020 Election Implications for Research Transparency
US equity research funding has long been regulated by Section 28 (e) of the Securities Exchange Act of 1934. While subject to occasional interpretive updates, one critical principal has remained unchanged (under both parties) since the abolition of fixed equity commissions in the US in 1975: that managers have "safe-harbor" to use client commissions to purchase research on behalf of a fund as long as it is "reasonable".
That is almost certain not to change under this Presidential transition either. What may change however, are certain interpretations of 28 (e) as a result of three key factors:
A tendency for the SEC under Democratic Administrations to be more responsive to asset owners (pension funds/ mutual funds) that other market participants such as investment banks/alternative asset managers.
The dichotomy between research funding in the US and Europe under MiFID II. While using client money for research remains possible in Europe under MiFID II, it requires considerable transparency (at a fund level) from the asset manager and the explicit approval of the asset owner. For a variety of reasons, the vast majority of European managers have opted to fund research via their own P&L (the other method available under MiFID II). Critically, from a US perspective, this includes many US-domiciled managers who are also paying for research via P&L for their European clients, but continue to charge US asset owners for research in the traditional fashion. (Footnote: Although post-Brexit, there are suggestions from the AMF and the European Commission to potentially "re-bundle" research commissions for a substantial percentage of European stocks, these are, as yet, proposals).
Increased "Activism" from US Asset Owners. Unsurprisingly, US asset owners have questioned why they continue to pay for research on behalf of US-based managers who are footing the bill for their European clients. However, rather than demanding reflex equivalent treatment, they have determined a series of conditions under which they would be comfortable continuing to fund research (presumably as they see some advantages in doing so).
Asset Owner Approach to the SEC
In the early summer of 2019, three organizations wrote a joint letter to the SEC. These were the Council of Institutional Investors (135 US pension funds with AUM of ~$4 trillion), the CFA Institute, and Healthy Markets.org, an advocacy group promoting market transparency. They recommended that the SEC make the following a conditions for asset managers to continue to use client money for research:
That managers disclose research budgets at a fund/client level.
That managers demonstrate that the asset owner's research commissions were spent for the benefit of their portfolios and were not subsidizing other investors.
With these assurances they would continue to fund manager research budgets, even for managers who were paying for research for other clients via their P&Ls.
Later that year, similar recommendations were made by the SEC Investor Advisory Committee. Established under the Dodd-Frank legislation, the SEC has a statutory obligation to formally respond to the Committee's recommendations.
The SEC did not respond to the Investor Advisory Committee's recommendations. This does not mean the issue has receded, particularly in light of a Democratic Administration (and potential re-bundling efforts in the EU).
Implications for Managers Using Client Money for Research in the US
The vast majority of managers using client money in the US cannot meet these standards currently. This would require:
- Fund-level ex-ante research budgets
- The mapping of specific research services to them to demonstrate lack of cross-subsidization.
The implications of this change are far from trivial in terms of the profitability of active managers. Frost estimates that if active equity strategies had to absorb their estimated 2019 research costs ($6.2 billion) though their P&L, the pre-tax profits of those strategies would be reduced by almost 40%.
This remains a key forward-looking regulatory risk. The post-MiFID II European experience suggests that the provision of research transparency is a very small price to pay to avoid this outcome.