MSCI says no to China

Last night, MSCI, the world’s largest indexing firm, announced that it will not be adding China’s A shares as constituents of its widely followed EM index.

It has also made a number of comments which were of interest to global emerging funds following Pakistan, Nigeria, Argentina and Saudi Arabia.

In summary:

1. For passive EM funds, the MSCI EM index is the most significant globally by far, with around $1.5 trillion of indexed investment. For active investors, any change in the weighting of the index (which they are benchmarked against) forces them to reassess the composition of their portfolios.

2. MSCI pointed to a number reasons behind their decision regarding China’s A share market, the main one perhaps being capital mobility. First and foremost, the monthly repatriation limit (the amount of his total capital the investor is able to withdraw from the market during one month) of 20% is considered too low, especially should the fund be faced with redemptions. The time-consuming and opaque process of receiving approval for a quota (allowing investors to invest in Chinese stocks) is also a factor. On top of this, the need for preapproval of financial products on foreign stock exchanges that are linked to A-share indices has not been yet addressed.

It is important to note that China is already the largest component of the MSCI EM Index, making up over 25% of the index. This is made of up of ADRs of Chinese companies listed in NY or Chinese shares quoted in Hong Kong. The domestic (A-share) stock market — the largest in the world after US — is not included in the index.

3. MSCI announced that Pakistan will be reclassified as an Emerging Market. Given its current account deficit and need for capital to drive steady growth, many observers agreed that Pakistan was the biggest winner from yesterday’s announcement.

4. Argentina will be reviewed for a potential upgrade. In December 2015, the Argentinian Central Bank abolished foreign exchange restrictions and significantly relaxed the capital controls that have been in place for a number of years. These changes have resulted in a floating currency, the elimination of cash reserves and monthly repatriation limits on the equity market, as well as a significant reduction in the capital lock-up period for investments.

5. Nigeria may be removed from MSCI’s Frontier Markets Index and reclassified as a stand-alone market due to capital mobility issues. This may even come as soon as November this year. Early last year its Central Bank pegged the local currency to the US dollar resulting in a sharp decline in liquidity on the foreign exchange market. Hence, the ability of international institutional investors to repatriate capital has been significantly impaired to the point where the investability of the Nigerian equity market is being questioned.

6. MSCI said that it welcomes the recent market enhancements announced in Saudi Arabia, which opened its market for the first time to foreign investors last summer. These include changes to the rules for qualified foreign investors, settlement cycle of listed securities, elimination of the cash prefunding requirement and the introduction of proper delivery versus payment. Many of these are on course to be implemented by mid-2017 and will bring the Saudi equity market closer to EM standards.

Sources: MSCI, FT, Natixis

Equity Crowdfunding enters Public Markets

Equity crowdfunding, a name given to a process where retail investors use online platforms to make investments primarily in start-ups, had a record year in the UK, a trend driven by various tax breaks (including SEIS) and light touch regulation. In percentage terms, equity crowdfunding is today the fastest growing component of UK’s alternative investment scene, growing (albeit from a small base, see figure below) by 410 per cent between 2012 and 2013, according a report published by Cambridge university, Berkeley and Nesta.

In March this year, UK’s Financial Regulator, the FCA, has made its first attempt to oversee the sector, stipulating that only experienced investors can invest largest sums and that backers can only invest up to 10 per cent of their investable assets. It did so acknowledging the fact that crowdfunding is industry well positioned for growth, and it will be a space we should expect further regulatory developments.

It is also interesting to observe how crowdfunding is slowly and selectively entering the public markets using specialised niche platforms to raise more capital. There are just a few sparse examples today, however it is something worth keeping an eye on as the industry grows.

In October, Chapel Down winery listed on smaller companies market in London raising £3.95m through crowdfunding. Triodos Renewables, a green energy company, is seeking to raise £5m in its second crowdfunding share issue. As of this morning, they have raised just over £2 million from 53 backers, and they are doing so via a technology based platform Trillion Fund which prides itself as being a crowd financing platform for renewable energy projects.

Technology’s potential to ‘emerge’ markets

Earlier this year, one of the largest remaining ‘closed’ emerging markets, Iran, followed Saudi Arabia in opening up its stock market to foreign investors as financial sanctions were officially lifted following last year’s breakthrough nuclear deal between Iran, the US and other world powers.

Emerging and frontier market fund managers are now looking closely at Iran to evaluate its investment potential, as shown by the rapidly growing number of Iran-focused funds as well as the increase in investor travel to Tehran during the last six months. The Tehran Stock Exchange already has a large, diversified and liquid stock market with more than 400 listed companies and a market capitalization of around $90bn. On top of this, the country’s IPO pipeline is potentially as large as $100bn, an enticing prospect for international investors looking for growth opportunities.

Before they are able to invest substantially in Iran, investors must first satisfy internal compliance teams by getting to grips with a market where investor relations and corporate governance standards still have a lot of catching up to do. This is usually a long and fairly painful process as investors, companies and regulators move at different speeds, speak different languages and follow different practices.

Technology could play a vital role in helping companies in countries who are entering the global capital markets arena for the first time, such as Iran and Saudi Arabia, to integrate and engage with the international investment community. It’s probably fair to say that the success of technological innovation in this area will be based largely on its ability to help companies to level the playing field between global investors and local investors.

The investor relations community has been slow to embrace innovations which are already revolutionising other industries. A Google Street View of the Emirates Airbus A380 for example gives travellers a full virtual product tour of the plane from their desks. Bernie Sanders used the 360 interactive video to great effect at his rally in the run-up to the Iowa caucus.

For most fund managers, there is no substitute for a face-to-face meeting or a company site visit, during which they can see the whites of management’s eyes and walk around the corridors of the company’s headquarters. But as global portfolios become more and more diversified, technology could help investors to cover more ground by increasing the effectiveness of ‘remote’ engagement at a fraction of the cost. Forward-thinking IR teams could adapt 360 technology to enable analysts and investors to interact not only with company premises, but also with senior executives and product managers. In a few years, the Oculus Rift headset could take this idea a step further to provide an even more immersive experience.

Simple smartphone applications allow ordinary consumers to order taxis, find dates, book flights, order takeaways and operate their central heating from the office. They allow warehouse managers to control stock and doctors to monitor patients’ blood pressure. At the same time, IROs and fund managers still rely heavily on emails, phone calls and business trips to conduct most of their daily tasks, which require time, money and organisation. In this environment, it is perhaps unsurprising that the process of building knowledge, trust and confidence in a company or market takes as long as it does.

For innovation to be embraced, it must make the fund manager’s job more efficient without forcing him to surrender his competitive edge or limiting his access to the company in any way. It must help the IRO to tell the company story more efficiently and to a wider audience. The opportunity for such a solution is perhaps greatest in emerging and frontier markets given the lack of existing IR infrastructure and desire for short-term international growth. Despite still being relatively undeveloped from a global capital markets point of view, countries such as Iran, China and Indonesia boast increasingly tech-sophisticated consumer markets, which perhaps bodes well for their respective corporate counterparts.

Technology innovations could offer open-minded IR teams in emerging and frontier markets a unique chance to quickly close the gap between them and their richer, more experienced developed market rivals. The lack of an existing process for engaging with international investors may even give them an advantage over established companies reluctant to think outside the box and adapt.

This article first appeared in the spring edition of UK IR Society’s magazine ‘Informed’.

Evolving face of institutional equity business

A interesting Bloomberg article titled “Wall Street Cracks Down on Free Sharing of Analysts’ Notes” has crossed our desk last week ignited a discussion within our team about the the market for investment research.
The article points out how brokers, to some extent driven by regulatory pressures, are overhauling the process of producing and distributing of research and using online portals to track what gets read and by who- and bringing closer to be able to finally see how much investors are willing to pay for analyst report.

As a refresher, most of equity commissions paid by investors to brokers are split into two components: Execution and Non-Execution. Execution component pays for physical cost of trading and cleaning the transaction, and non-execution pays for other services such as investment research and corporate access. In a bundled commission environment, those two components are not separated and captured by the broker executing the equity trade.

CSAs (introduced in 2007) enabled fund managers to separating commissions into payment for executing trades from payment for research, however most argue they were not not sufficient to determine the value of services consumed, nor control spending. Furthermore the commissions (whether bundled or unbundled) actually belong to the asset manager’s end client however the asset manager has the full discretion of how to spend it.
The direction of regulatory travel is towards complete unbundling, something that we believe , will reshape the economics of institutional equity business, carrying with it serious implications to asset managers, sell side firms and IR teams.

We see those five questions are at the crux of the debate:

1- What has been happening to global trading commissions, which still drive the vast majority of supply of research and corporate access services?
Post crisis environment brought about the worst bear market for equities since the 1930s. Combination of depressed equity valuation, lower trading volumes, lowers fees generated from IPOs and primary market activity, a steady shift from active to passive investing meant a significant decline in available commissions for equity businesses providing research and corporate access. The effect was particularly severe outside North America where commissions are calculated as a percentage of the value of the share price. Emerging markets as a whole have also suffered their own set of dynamics which have further reduced comission dollars and meant instances of banks shutting down entire operations (ex. DB in Russia, CLSA in , Nomura in)
So what did this mean for broker revenues? Frost Consulting estimates that there has been a 43% reduction in global commissions for equity research, leading to a 40% reduction in budgets allocated by the 600 or so reduction in budgets allocated by the c 600 firms producing equity research from US$8.2bn at the peak in 2008 to US$4.8bn in 2013.

2- What would regulators like to see commission payments used for?
In short, just for execution. The UK’s Financial Conduct Authority wants brokers’ research to be treated as a cost to the manager and paid out of their own P&L rather than paid for out of client funds- a reform known as “unbundling”. This may eventually lead to a “priced” market for investment bank research which could transform the market in which consumers (investors) only receive the products they want and purchase in which personalisation, interactivity, niche focus will be critical for commercial success. The changes could provide an advantage for independent and specialist firms. In 2014, the FCA already banned using client commission payments for Corporate ACcess in the UK in 2014, a rule that is still looks that is yet to be adopted flouted

3- Are investors treating commission spending as if they were their your own?
Milton Friedman, the US economist, once said that perhaps the most wasteful form of spending is spending someone else’s money on somebody else: you are then “not concerned about how much it is, and not concerned about what you get get”. Perhaps there is a little bit of thoughts that can be applied to current discourse in the asset management industry. Regulators feel that allocation of spending (and hence the pricing) of broker services would have been different if investors had to pay for it from their own pockets. Surely, they argue, more considration would go into what is valueable, hence

In last year’s survey by the CFA Society UK, almost half of respondents think that Investment firms in the UK do not manage dealing commission — which is a client asset — as carefully as if it were their own money.

payments as if it were your own?

5- What do investors value most from brokers and how is that value priced?
Investors consume a number of services from brokers, and

Experts say that one of the trickiest aspects of pricing research is working out its value.

Reverse roadshow / investment trip to
Face to face management meeting at home
An Investor Conference
Call with reserach analyst
A report

Related articles
Bloomberg: Ballad of a Wall Street Research Analyst, Told by Brad Hintz

Handling Investor Relations during a Crisis: Lessons Learnt from the 2011 Egyptian Revolution

This is a guest post from Omar Darwazah, Director, Investor Relations at OCI N.V.

It seems that the entire world is in a constant crisis today. From Argentina to Russia to Turkey to the United States, there has been no dearth of crisis management situations which investor relations (IR) professionals have had to face. Whether it be political upheavals, civil wars, border disputes, fiscal disasters, wild foreign exchange fluctuations, military coups, capital controls, crazy presidential candidates or deeply entrenched state-sponsored corruption, investor relations professionals globally are finding it more difficult to craft their respective companies’ equity theses and messages to the investment community without finding themselves having to discuss geopolitics and global socio-economic trends. In 2011, I was Director of Investor Relations at Orascom Construction Industries (OCI) in Cairo, Egypt. I found myself in the middle of a historic event; I faced a systemic crisis that plagued the entire country as well as the company, it would forevermore change Egypt and its investment landscape.

On January 25, 2011, I readied to attend an annual Bank of America Merrill Lynch investor conference like I had done in years past. I boarded an 8am flight from Cairo to London to kick-off to OCI’s investor relations program and prepared presentations to current shareholders and prospective investors. Upon my arrival in London five hours later, however, the Egypt I had always known — run by the ironclad dictatorship of Hosni Mubarak and the brutality of his state police — had changed forever. A revolution was in the making. Thousands of people took to the streets to peacefully demonstrate en-masse against the regime. While I conducted meetings with investors on January 26, the state police clashed with protestors, the demonstrations turned violent, and the Egyptian equity index crumbled. The investors I was to meet at the conference turned to me for unbiased, candid interpretations of events on the ground.

As the revolution unfolded, the company’s CEO entrusted me to continue meeting investors. For 3 weeks I operated in crisis management mode and conducted over 70 one-on-one on-site meetings in London, Dubai, New York, Boston, Chicago, Frankfurt, Zurich, Geneva, Amsterdam and The Hague.JPMorgan invited me to lead a conference call with investor relations directors from other Egyptian blue-chip companies to advise them on handling the crisis. There was no hand-in-glove approach to managing the situation but I did share the following observations with my colleagues:

  1. The challenge of speaking to investors throughout the Revolution was primarily exacerbated by the lack of visibility on the ensuing chain of events

  2. Communicating with senior management on the ground in Cairo proved to be difficult given the lack of internet or mobile phone access throughout the 18 days of the Revolution

  3. For a contemporaneous update, I relied on speaking to various team and family members as well as friends by landline in order to provide investors with candid advice on the situation

  4. The routine questions on the performance of the company were never even asked and investors turned to me for unbiased interpretations of the unfolding events

  5. I combined my in-depth knowledge of Egypt, undergraduate training in Political Science and Economics and oratory skills to field difficult questions and deter a crisis within the global investment community. Speaking on behalf of the company and its performance became secondary in importance

In hindsight, the mere fact that I was present outside of Egypt and able to travel and meet investors proved to be extremely valuable. While serendipitous, the lesson learnt during my experience was that irrespective of the gravity of the crisis at hand, it is pertinent for IR professionals and management to be readily available and present to meet with the investment community even if they have bad news to report to them. That year, I ended up conducting over 300 one-on-one meetings in 25 cities globally. Here are some key takeaways from my experience:

  1. Investors appreciate full transparency and candidness during periods of high market uncertainty

  2. As an IR professional, be ready to simulate various scenarios during one-on-one meetings with investors with subsequent potential risks and mitigants of these scenarios

  3. Be ready to discuss broad topics that are typically not addressed during routine investor meetings

  4. Exogenous factors affecting company performance in times of uncertainty should be quantified as much as possible (i.e. impact on earnings, days of business interruption etc.)

  5. During a crisis, liaise closely with senior management and provide key updates and feedback from the broader investment community including analysts and investors as this helps with internal risk management

  6. Keep an open line of communication with the market, be ready to conduct a significantly larger number of investor meetings and global roadshows

  7. Disseminate factual information in writing in official company documents (i.e. press releases and results presentations) but leave speculative discussions, political opinions and forward looking statements in conversation only

  8. The best line of defense in a period of high and consistently evolving uncertainly proved to be a good offense (i.e. an aggressive roadshow strategy and meeting schedule)

That year, OCI’s share price outperformed almost all blue-chip companies on the EGX30 declining 30% versus almost 50% for the EGX30. Moreover, my crisis management strategy was acknowledged by the Middle East Investor Relations Society (MEIRS). As voted by the global buy-side and sell-side community, I won the MEIRS “Best Investor Relations in Egypt” award that year. I will no doubt face other crises during my IR career, they might not carry the same severity and intensity of the Egyptian Revolution in 2011 (or maybe they will!) but I believe the aforementioned takeaways are valuable in a multitude of crisis contexts; remember candidacy first, always.

BNY Mellon: 2016 Global Trends in IR

BNY Mellon Depositary Receipts group has very recently published their annual report on global trends in investor relations. With 550 companies surveyed from 54 countries, it is probably the most comprehensive barometer of the current themes in our industry. The report provides large amount of comparative information on how listed companies are adapting to the changing marketing condition, touching on topics such as budgets, allocation of management’s time for buy side meetings, reporting lines, use of sell-side, measuring team effectiveness as well as insights into evolving areas such outreach to ESG investors and the use of technology.

Firstly as a qualifier, lets consider the demand side dynamics for global issuers. Despite the inevitable short and medium term swings in investor appetite for a given asset class, market or industry evidence that investors all around the world are diversifying and are increasingly adding a global component to their portfolios. Our own analysis point to over 4,000 institutional investors who hold emerging market securities, versus only 400 in early 20oo’s. BNY Mellon’s own estimates point to number of investors that hold DRs (or, roughly translated as those with global mandates) has increased from from 3,261 in 2Q10 to 4,533 in 2Q15. This figure will, we believe, continue to grow, and present opportunities in areas where a- investors previously held most domestic bias and b- have considerable assets under management in active management and c- see diversification opportunities globally.

With this backdrop, a couple of things to note from the survey:

  • IR teams are working harder to address the growing global investment opportunity. This is evidenced by 1- investor meetings taken by C-suite executives and IROs inside and outside their home markets have increased by 12.6% compared to 2013 (from 250.6 meetings in 2013 to 282.3 meetings in 2015). 2- companies almost doubling their IR budget allocation to travel, from 12.8% in 2013 to 24.3% in 2015, which in turn is interesting to contrast with the slight decrease in companies holding analyst/investor days (63% to 59%).

  • Top 10 sources of new investor demand in five years time, according to surveyed companies, will split evenly between emerging and frontier market. US, UK, China, Germany and Singapore lead the pact.

  • Technology tools, such as conference call/webinar and video conference calls has been increasingly used in toolkit of a global IR officer (72% in 2015 vs. 63% in 2013 and 41% in 2015 vs. 34% in 2013). With the management and IR team time relatively fixed, and the buyside universe expanding — there is no element of a doubt that tools that help reach new investors can increase reach and efficiency, at a fraction of a price. We are strong advocates of using new tools to tell a company story . Can any one see how virtual reality or 360 videos can be applicable to the world of investor relations?

  • Despite the wave of regulations on how investors will pay for research and cooperate access, brokers continue to dominate the company non-deal roadshows arena, however with some signs of this changing. 10% of companies have organised NDRs themselves, up from 5% the previous year. Interestingly, companies rely a lot less on brokers nowadays to provide them with post meeting feedback, and rate quality targeting and introductions at upmost importance.

  • Growing ESG focus — The survey notes that there has been a strong increase (from 37% to 46%) in companies who have strategies in place to communicate with key investors on corporate governance issues on a regular basis, with top issues addressed being Board composition (76%), Transparency and disclosure (71%) and Remuneration (60%). Despite that the actual number of investors who reach out to ESG focused investors is still low (30%), however likely to rise. There is evidence to suggest that institutional investors are increasingly committing to ESG-focused principles in their strategies — whether that be through a more active engagement as shareholders or divestment strategies.

Source: BNY Mellon Depositary Receipts Market Review 2015, BNY Mellon Global Trends in Investor Relations 2015

Developments in Sovereign Wealth

Invesco Asset Management recently surveyed 59 sovereign wealth funds (SWFs) worldwide and published a report outlining some of the key themes. A few points which we found particularly interesting:

  • Studying the investment preferences of SWFs, there is continued growth in emerging market allocations for new assets, however developed markets remain a preferred choice. Two headline corrections visible are: relationship between emerging market investment and infrastructure and relationship between developed markets and real estate. As discussed earlier, a number of funds are also beginning to target frontier markets.

  • SWFs cite a number of factors which restrict their investment in emerging markets, such as political instability, corruption, regulation change and a lack of legal protection. These risks are of particular concern to SWFs because they cannot be quantified and many emerging market investments are prohibited by risk management guidelines irrespective of potential returns.

  • The biggest challenge for SWFs is sourcing new deals. Respondents explained that sourcing deals is toughest in infrastructure and is driving greater collaboration between SWFs, especially those across emerging markets. Good example of this is last week’s announcement of Saudi SWFs $10bn into Russia via its RDIF fund.

  • As we have noted earlier with some of largest pension funds, SWFs are relying more on in-house expertise to manage their funds in an effort to bring down costs and improve performance in the low-yield environment. The report points out that the percentage of global equities managed in-house rose to 34 percent from 26 percent at the end of 2013 (see chart below). Historically the vast majority of the fund’s equity investments were outsourced to external fund managers. It is a trend worth watching, and it continues it will mean that SWFs will continue to grow in relevance to Investor Relations Teams teams. Many of the largest funds are already frequently engaging management teams.

SWFs assets in perspective

Total Mutual Fund AUM: $74.3 tr

Global Pension Fund AUM: $37.3 tr

Sovereign Wealth AUM: $7.3 tr

Exchange Traded Funds AUM: $ 3.0 tr

Hedge Fund AUM: $2.8 tr

Additional reading

Reuters summary of key findings of survey

Closir Blog: Global pension funds to increase in-house management of assets

Closir Blog: Update for Norges Bank Investment Management Strategy

Source: Invesco Global Sovereign Asset Management Study 2015

Drivers of Innovation in Fund Management

A research study published last week by London-based think tank Create Research deserves a closer look. Amin Rajan, who is both CEO of Create and an early mentor to Closir, conducted a study into how digitisation, and the intrusion of internet and mobile players, looks set to reshape the asset management industry during the coming months.

Fund managers themselves have been slow to embrace technological innovation, although in the last 12 months a number of global trends have started to help the process along: An exponential growth in number of affluent investors An increasingly tech-savvy population Greater flexibility in pension contributions and longer life expectancy Increasing demand for transparency and synchronisation from regulators Growth of geographically ‘portable’ investment products such as ETFs The popularity of social media channels spilling over into the finance community The report outlines the emergence of several new models: In the evolving marketplace, virtual advisors offer the mass affluent market a streamlined communication process through mobile and digital media, enabling them to take advantage of technology while retaining some of the personal touch.

Online advice platforms, or ‘robo advisors’ as they are being called by some, have already started to offer retail clients the chance to build personalised portfolios using proprietary algorithms. Fund consolidation portals will help them to aggregate and manage investible funds across multiple platforms. Given the obvious opportunities these trends present for ambitious and resourceful technology players, it’s unsurprising to hear Google and Apple mentioned as potential disruptors. Create’s report suggests mobile phone providers may also be well positioned to enter the fray. Although industry players have been losing sleep over the tech giants for some time, there are obvious hurdles for data-sharing social technology companies in an industry which is defined by a strong risk culture, regulatory oversight and the importance of data security.

Strategic partnership with finance players may be a good option for technology and mobile companies, as it offers them a way to mitigate these concerns while making the most of complementary skill sets. There have already been some high-profile collaborations, with Aberdeen Asset Management forming an alliance with Google and Canadian mobile provider Rogers Communications partnering with Canadian bank CIBC. Change may be gradual in an industry traditionally resistant to technology. Create points to the airline industry as a successful model, where both customers and providers quickly adapted to the increased efficiency offered by technology as concerns over security proved to be exaggerated.

Research Regulations: the Quest for Clarity

More than 200 investment professionals gathered last month at the Institute of Directors (IoD) in London for a series of panel discussions on investment research, and how it should be provided and paid for. With corporate access now formally ‘unbundled’ from trading execution services in the UK (meaning fund managers must pay brokers to organise meetings with company management separately and out of their own pockets), the focus has shifted to research, which the FCA decided not to touch the first time around.

CSAs (commission sharing agreements) already exist to keep fees for execution separate from fees for other services such as research and corporate access, although the precise value of each remains somewhat unclear. Now faced with the prospect of potentially having to pay for all research themselves, rather than passing the cost on to their end clients, fund managers (and regulators) are taking more of an interest than ever in its cost and value.

At the IoD there appeared to be broad (although not unanimous) consensus that ‘something needs to be done’ to resolve the cost/value question, although there was some difference of opinion on exactly what and how.

What is wrong with the current research model?

Regulatory scrutiny is centring on:

  • the use of research as an ‘inducement’ (so investors will execute trades with the broker publishing the report)

  • the fact that the current model discourages competition

  • the lack of transparency around both cost and benefit

The FCA’s main goal is to ensure a fairer, more competitive, more efficient market. The key to this is transparency. CSAs were introduced to bring greater clarity to the whole commission payment structure, although the feeling is that they actually tend to muddy the waters, encouraging brokers to juggle commission between services to ‘reverse engineer’ fees.

Thus one of the regulators’ top priorities is to cut the strings that are attached to ‘free’ research and encourage greater competition for individual sell-side services.

How much should investors pay for research?

On the face of it, imposing arbitrary prices on research reports would seem to make little sense and in any case is almost certainly beyond the remit of regulators. The popular view seems to be to let the market decide.

Most investors agree that the aim of regulation in this case should be deregulation: once you remove all barriers to transparency and competition, the free market will determine the price through simple supply and demand economics.

In most cases it is still the end users who are paying for research and other services (through trading commissions), although making fund managers cover these expenses out of their own pockets should help to close the gap between price and value and stem the tide of ubiquitous ‘free’ research.

How is research currently consumed?

The vast majority of institutional investors undertake a quarterly voting process to evaluate and rank the quality of the sell-side research offered by the various providers. Once rankings are determined, budget is allocated accordingly (different services carry different weights).

Investors also rely to a varying extent on their own research and more often than not, on the sea of reports which are available either from one of the major data providers or through analyst connections. Many supplement ‘bundled’ sell-side research with reports from trusted, independent providers. When the budget is spent, they go ‘execution-only’.

The potential rule changes are forcing investors to think long and hard about what they actually need and whether the research they currently consume is worth what they might have to pay for it. As a result, fund managers are being encouraged by their firms to use whatever tools are at their disposal to more closely monitor consumption and assess value.

In recent years there has also been a growing tendency for buy-side firms to bolster their own in-house research capabilities, thereby reducing their reliance on potentially expensive sell-side services. This of course requires time, money and expertise, but the potential benefit for individual firms in cultivating their own proprietary investment ‘edge’ is obvious.

How would rule changes affect the market?

Opinion seems to be divided on how potential changes would affect the market. Below are some of the main advantages and disadvantages to unbundling research raised at the conference:

Potential advantages

  • Execution services would move more freely

  • Research would become more specialised

  • Independent research firms would benefit from a level playing field (one attendee suggested consumption may triple from its current level of 8% per firm)

  • Similarly, sell-side firms who produce research reports in markets where they do not execute trades (e.g. Standard Chartered in Russia) would not be unfairly excluded

  • A growing culture of in-house buy-side research would help to differentiate firms

Potential disadvantages

  • There may be a reduction in the depth and breadth of sell-side research

  • Small- and mid-size firms may be excluded from sell-side research distribution

  • Boutique sell-side firms may lose out

These discussions are likely to continue until the respective regulatory bodies can provide some clear guidelines on rule changes and timescales. Many at the IoD expressed growing frustration that, having taken the lead on this issue, the FCA seems now to have backed away; the recently announced delay of MiFID II has also left a number of important questions unanswered.

Some are putting their faith in the market to resolve these questions, the idea being that if a large minority of asset managers lead the way then the rest of the market will follow. There are already signs that this process is underway, with a number of firms reaching into their own pockets to cover not only corporate access, but also research. One of the more interesting quotes of the day came from a fund manager who said “If there is a distribution platform that works, research will unbundle itself”. Healthy markets have always been founded on efficiency.

The need for change is apparent, and now finally it seems the appetite is too. Hopefully 2016 will bring a new sense of purpose and clarity to an issue which continues to create uncertainty for investors, brokers and companies alike.

What does this mean for company IR teams?

Should the regulators decide to fully unbundle research, there would likely be a decrease in the amount of sell-side reports written and distributed, particularly on non-blue chip companies, as analysts begin to take a more focused, tailored approach. Investors would be forced to rely more on their own in-house capabilities and on information directly from the company. In both cases the role of investor relations takes on extra importance as fund managers are less willing to invest their own money in the expertise of brokers.

The likely growth in buy-side consumption of independent research would present an increasingly attractive option to companies looking to reach a wider audience of investors. There would be an opportunity for technology start-ups to follow in the footsteps of companies like Stockviews and SeekingAlpha to fill the gap left by free, ubiquitous, one-size-fits-all sell-side research.

As discussed above, regulatory changes are still some way off, so the best thing IR teams can do at this stage is to stay on top of developments and maintain best practice IR, strengthening connections with both sell-side and buy-side.

Are investors ready for a Digital Reporting Future?

This is a guest blog post Thomas Toomse-Smith from the Financial Reporting Council. The Financial Reporting Council is the UK’s independent regulator responsible for promoting high quality corporate governance and reporting to foster investment.

The internet and technology has revolutionised many aspects of communications; however, communications between companies and investors does not appear to have taken full advantage of this revolution.

In order to understand why this might be, and how reporting might evolve in the future the UK Financial Reporting Council’s Financial Reporting Lab (Lab) launched a project to look at digital reporting by companies. The Lab has issued its first report from this project. The report called Digital Present is based on analysis conducted by the Lab from in depth interviews with companies and investors. The interviews were supplemented with the results of an online survey of retail investors.

The report provides practical guidance to companies and highlights some areas where improvements could be made to what currently exists.

The importance of annual accounts

Annual reports remain of paramount importance to investors. However, investors prefer PDF for digital annual reports. They consider PDF not as a substitute for a hard copy, but as a progression from it. PDF provides the best mix of attributes of paper and digital annual report, but companies still could improve the PDF by thinking more about how to deliver the best experience with it on-screen.

Making sense of multi-channel

Alongside the annual report, companies use a range of other channels to communicate information Investors need to consume information on multiple companies in an efficient manner. However, company-produced tools, by their very nature, focus only on the individual company, and the multitude of channels leads to a significant proportion of them too failing to gain traction with investors.

Investors have specific feedback for companies on the most significant channels and tools:

  • Delivery of annual results presentations — Investors want multiple channels to be available (e.g. phone and webcast) preferably with supporting slides. Transcripts of the entire event, including all Q&As, is also deemed important.

  • Social media — Investors do not currently view social media as a useful channel for company produced, investor-focused information. It is seen as repetitive of other channels.

  • Investor relations videos — Many Investors are cynical about the use of video by companies. They consider them to be promotional in nature, and unfocused in aiming at many audiences. Those Investors that value them concentrate on nonverbal information such as body language.

  • Investor relations apps — Apps are not popular with investors. Many Investors find the need to have an IR app for each company prohibitive; they are concerned that this uses up space and adds clutter to their devices, especially when following multiple companies.

Investors who participated in this project suggest that companies:

  • Reduce duplication and focus development towards tools and channels which provide new or additional information.

  • Acknowledge that investors follow more than one company by making tools and channels more consistent in scope and operation with other companies, making them easy to access and locate.

  • Make the purpose of each channel or tool clear to investors, and clarify its contents.

Investors have shown they are open to innovation when it meets their needs to access information relevant to their analysis, across companies and time. To enhance current digital reporting methods and innovate further, it will be important for companies to build on the attributes of current reporting that investors identify as being most helpful.

The Lab will build on the findings from this stage of the project to inform remaining phases. In the second phase, ‘Digital Future’ the Lab will work with companies and investors to develop ideas of how companies could use digital reporting in future to improve their communication with the capital markets. Do you have views on this area? The Lab would be interested in hearing from ClosIR users. The Lab has released a survey alongside the Digital Present report seeking views from those involved in the production and use of corporate reporting. The survey will be open until the end of June and can be accessed here.

You can read the full Lab report here.

Investment Research: To Free or Not to Free?

Last week we published a blog in which we attempted to get to grips with some of the important questions that remain around the unbundling of commission for corporate access and trade execution. A Bloomberg articlethat came out around the same time entitled “Wall Street cracks down on free sharing of analyst notes” leads us nicely to the remaining piece of the unbundling puzzle, namely investment research.

The main objectives of the ongoing regulatory scrutiny of both research and corporate access are to eliminate conflicts of interest, increase market transparency and level the playing field. To this end, the revised rules on corporate access are fairly simple: if fund managers want their broker to put them in front of companies, they must pay for it out of their own, and not their clients’ pockets.

Research looks to be heading down a similar path. If, as expected, regulators demand that investors who wish to continue benefiting from broker research must pay an upfront, out-of-pocket yearly fee (which is not linked to trading volume or value), there are 4 possible outcomes:

  1. Brokers will continue to fund research as a loss leader

  2. Fund managers will fund research

  3. Companies will fund research

  4. Investors increasingly conduct and rely on their own research (in 2014 in-house buy-side research increased by 42%)

In reality, all of these things may happen to some extent. In 2000 the US SEC passed Regulation Fair Disclosure (Reg FD) requiring publicly traded companies to disclose material information to all investors at the same time, meaning in theory analysts are free to conduct and disseminate research to whomever they please. In the case of large companies, banks will almost certainly continue to pay as they chase business from companies as well as from investors. But this does raise certain issues.

As the Bloomberg article outlines, the main problem with expecting fund managers to pay for research themselves (besides the fact that they have been passing all costs on to their own clients for years) is that research reports are widely available online or from colleagues or contacts in the industry, free of charge. The sell-side switch away from “blasting out everything it produces” will take time, although it seems that technology will play an important role in restricting access and tracking readership.

One of ESMA’s criticisms of the current model is that buy-side firms are using their clients’ money to pay for research as part of an existing commission arrangement (meaning they basically get the service for free), effectively shutting independent providers out of the market. The regulatory amendments and the likely collapse of the current model should open the door wider for independent research providers, including some of those we highlighted in our previous blog with innovative models such as Stockviewsand SeekingAlpha.

The other likely consequence of limited distribution of research reports will be for analysts to adopt a more tailored, targeted approach. This could be crucial for an industry which is often slow to adopt new practices and technology. It is often the cheaper, more agile, independent providers who are quickest and best placed to respond to technology-oriented opportunities in the market, although as the article highlights, it seems that the big banks are already starting to cotton on to the competitive benefits of this approach.

What impact will this have on company IR teams?

A more specialised, less generic focus will surely bode well for companies across the board but perhaps especially for SMEs and those in emerging markets, who have historically tended to be lost in the sea of free blue chip research reports. Former NIRI national board chair Brad Allen, writing for IR Magazine, advises company IROs of all shapes and sizes to strive to be “the go-to source not just on your company but also on your industry”, rather than relying on analysts and databases to tell the story.

The reality is that while the unbundling of corporate access and research services remains a hot topic in Europe and beyond, it will be a while before legislation is formalised now that MiFID II itself has been delayed. Even in the UK there is a definite air of ‘business as usual’ as brokers, analysts and fund managers wait to see who flinches first.

In the meantime, IROs would surely do well to heed Allen’s advice. In emerging markets especially, a proactive and innovative, technology-friendly approach will help them to address the far more immediate concern of an increasingly jittery investment community. Good IR alone will probably not be enough to stem the current flow of capital out of EMs, but companies who tackle this issue head on now will be well placed to capitalise when the tide finally turns.

Activist Investor’s influence on Passive Funds

The cover story from this week’s Economist caught our attention, particularly as it relates to a number of IR themes we have been observing closely. Academic literature* examining the recent track record of US activist investors concludes that despite their reputation and short term focus they are more often than not a force for good, at least in terms of driving greater operating performance and shareholder returns.

The article draws attention to a polarity in today’s average shareholder structure, one that is particularly evident in the US. On one side of the spectrum is ‘lazy money’ which comprises a growing number of computer-run index tracking funds, ETFs and mutual or pension funds, which generally prefer not to get too involved in radically altering the strategic direction of the companies they invest in. On the other are large funds which buy entire companies, often taking them private and actively dictating strategy.

Activist investors can fill a key corporate governance void by influencing passive funds and ‘lazy money’ to take an interest and support either the activist investor or management’s chosen course of action. The long-only funds holding the majority of the free float generally assume the role of ‘blocker’ or ‘enabler’ for activist campaigns so the more involved they are the better. This involvement looks set to increase as activist funds grow in popularity. In 2014, a fifth of flows into hedge funds went to activist investors, resulting in their AUM rising from $55bn to $120bn over a 5-year period.

The two largest providers of passive products, Blackrock and Vanguard, have already pledged to work more towards ‘long term interests’; this will inevitably include increased contact with company boards. Company management and IR teams may also make a more proactive effort to establish relationships with passive managers, something which was not really considered as recently as a few years ago.

The final angle of the debate centres around the potential for transferring the US-style activism model across the Atlantic, particularly given the arguably limited opportunities in the US (only 76 companies in the S&P 500 registered a poor 5-year Return on Equity and only 29 trade below their liquidation value). European investors will argue that they already have more say than their American counterparts on corporate governance issues such as renumeration and board appointments, and differences in culture as we move east mean that many activist fund demands are often settled discretely and diplomatically.

Long Term Effects of Hedge Fund Activism, Lucian A. BebchukWSJ

Unbundling: 4 Questions to Consider

As UK’s FCA and European regulators continue to clarify their stance on commission ‘unbundling’ we thought it might be useful to quickly revisit the debate and attempt to answer a few questions at the core of the debate.

To recap (also see our earlier piece: Brief history of the dealing commission), most equity commissions paid by investors to brokers are split into two components: execution and non-execution. The execution component pays for the physical cost of trading and clearing a transaction; the non-execution component pays for other services such as investment research and corporate access.

Commission sharing arrangements (CSAs) enable fund managers to keep the two components separate, however until recently they have tended to be ‘bundled’ together into one commission payment. CSAs have been criticised for their lack of transparency in helping fund managers to determine the value of the services consumed and to control spending. Furthermore, even though the fund manager has full discretion in how the commission is spent, it is paid for by the fund manager’s end clients.

In Europe at least, we seem to be heading towards complete unbundling, which will likely have profound implications for asset managers, sell side firms, IR teams and entrepreneurs alike

1. How have global trading conditions affected made the supply of research and corporate access services?

The post-credit environment has ushered in the most difficult period for equities since the 1930s. This is due to a huge combination of factors: depressed equity valuation, lower trading volumes, lower fees generated from IPOs and primary market activity, equity market fragmentation and HFT, and a steady shift from active to passive investing. All of this has contributed to a significant decline in available commissions for equity businesses providing research and corporate access. Emerging markets have fallen prey to additional dynamics, which have further reduced commission dollars from trading and caused banks to scale back their securities operations and in some cases shut down entirely.

So what does all of this mean for broker revenues? Frost Consulting estimates there has been a 43% reduction in global commissions for equity research, which in turn has led to a 40% reduction in budgets allocated by the 600 or so firms producing equity research, from $8.2bn at their peak in 2008 to $4.8bn in 2013.

2. What would regulators like to see commission payments used for?

The UK Financial Conduct Authority (FCA) wants broker research to be treated as a cost to fund managers to be paid out of their own P&L rather than out of clients’ funds (‘unbundling’). This may eventually lead to a ‘priced’ market for investment research in which consumers (investors) only receive the products they are willing to pay for. It seems reasonable to assume that this will lead to greater personalisation, interactivity and niche focus. Such changes could offer independent and specialist firms an edge, as well as present opportunities to the long tail of companies often overlooked by sell-side analysts. In 2014 the FCA banned the use of client commission payments for corporate access in the UK, a rule which made waves in the investment community but has yet to be fully adopted or implemented.

3. Are investors paying commission responsibly?

Milton Friedman, the US economist, said that perhaps the most reckless form of spending is that which involves someone else’s money as you are “not concerned about how much it is, and not concerned about what you get”. Perhaps this thinking can be applied to commissions. Regulators feel that the amount of money allocated to (and by extension the pricing of) broker services would be somewhat different if investors had to pay for it out of their own pockets, and that more thought would go into the true value of these services. In last year’s survey by the UK CFA society, almost half of respondents agreed that investment firms in the UK do not spend their clients’ commissions as carefully as if they were their own money.

4. How do investors assess and quantify value?

Despite the ubiquity of research and corporate access services, there is no uniform pricing model and industry experts agree that it’s a tricky subject. As Matt Levine points out in his column, one of the main challenges is that equity research, at least from a regulatory point of view, is classified as material, non-public information. As such, institutions have a responsibility to distribute it ‘fairly’. Something will have to give.

Many would argue that while these services provide a broad benefit and ultimately make markets more efficient (by helping to disseminate information and underlying analysis more widely), the model only benefits a narrow segment of the market. Asset managers are investing more and more in their own in-house research teams, and in some cases in dedicated corporate access desks. Numerous independent research providers and start-ups have also entered the market to fill the gaps and propose new models. Many of them, like us, believe that technology can play a complementary role and perhaps solve one or two issues along the way.

Saudi Arabia to Open its Equity Market to Direct Foreign Investment

After a number of years in the making, the Saudi Arabia authorities finally announced last week that Qualified Foreign Institutions (QFIs) will be allowed to invest in shares listed on the Tadawul starting from June 15th, 2015. While foreign investors have been able to invest in Saudi Arabia since 2008, this has been limited to ETFs, swaps and P-notes, none of which allow direct ownership of the underlying equity. Opening the market to QFIs as a first step is a tried and tested approach in emerging markets (e.g. China in 2002, India in 1992, Taiwan in 1991). Institutional investors who do not meet the criteria for investing directly will likely continue to use the existing products mentioned above.

The Tadawul is the Middle East’s largest and most liquid market, and effectively the largest closed emerging market today. The 165+ listed companies have a combined market capitalisation of over $550bn, with petrochemicals and financials industries the dominant sectors. Recent IPOs have added more consumer and non-cyclicals to the market. A number of commentators are speculating that Saudi Arabia could receive an emerging market classification from index provider MSCI within the next two years, which is in turn likely to drive additional investor interest. MSCI’s Sebastien Lieblich was quoted last year as saying that if Saudi Arabia were added to the Emerging Markets Index it would constitute around 4 per cent of the total market, similar to Mexico and Russia. This development would mean that Saudi Arabia could make it into the top 10 rank of EMs as classified by the MSCI (see graph below).

The Kingdom presents investors with a unique set of dynamics. Its economy has gone from strength to strength in recent years as it has benefited from high oil prices and output, strong private sector activity, increased government spending, and the implementation of a number of domestic reform initiatives. Rising oil prices and oil production have also resulted in large external and fiscal surpluses, and government debt has declined to almost zero. With a population of over 30 million, over half of whom are under 25 years old, it is the region’s youngest and most populous nation. Of course, there are risks. First, the Kingdom’s dependence on oil revenue (over 90 percent of fiscal revenues and 80 percent of export revenues come from the sale of oil) leaves it hostage to fluctuating oil prices, as have been seen since the summer of 2014. Geopolitical tensions in the region further added to such worries. As with all emerging markets, there have been some corporate governance-shaped bumps in the road, however the opening of the market to foreign investors will undoubtedly help smooth the path to transparency and benefit companies and investors alike.

Sources: International Monetary Fund, Bloomberg, Morgan Stanley, MSCI

How to define Emerging Markets — Prof. Andrew Karolyi

A couple of weeks ago we were invited by BNY Mellon Depositary Receipts team to attend an interesting talk by Andrew Karolyi, Professor of Finance at Cornell University, who published a book last month entitled “Cracking the Emerging Markets Enigma”.

The book is intended to address the ongoing confusion around how we define emerging markets. Professor Karolyi stresses that much of the misunderstanding stems from an obsession with ‘growth’: a universal, ‘efficient’ model (which he proposes here) should take into account all relevant factors and provide a standardised evaluation of any market.

Professor Karolyi identifies six key areas which help us to classify individual markets both quantitatively and qualitatively:

1. Market capacity constraints (e.g. market cap to GDP ratio, bond market capitalisation)

2. Operational inefficiencies (e.g. commissions, taxes and costs, settlement cycles)

3. Foreign investability restrictions

4. Corporate opacity (e.g. governance and accounting standards)

5. Limits on legal protections (e.g. insider trading laws, self-dealing, directors’ rights)

6. Political instability

He then applies this six-pronged formula to 33 separate emerging markets, using regression analysis to assess the impact of each factor on foreign investment.

One of Professor Karolyi’s main frustrations is the need of the financial media to shoehorn all passing market trends into fixed, acronym-sized boxes. The most obvious example is the BRIC label, which may have made sense when it was coined by former Goldman Sachs economist Jim O’Neill in 2001, but has since lost all meaning given the wildly divergent paths of Brazil, Russia, India and China in the intervening years. A quick glance at the spiderweb diagrams below illustrate this point well:

To put this in context:

Professor Karolyi agrees that there are additional factors he does not take into account that fit somewhere into the six classification categories (e.g. freedom of the press, demography), but thinks the rating system provides a picture of each market which is as accurate, comprehensive and balanced as possible. He also accepts that there are a number of so-called ‘frontier’ markets for which there are simply not enough data to build an accurate model. This in itself tells a story about the quality of governance in these markets.

One of the research’s key findings is that only five out of 33 emerging markets (Israel, South Korea, Peru, South Africa and Taiwan) were overly favoured by global investors in 2012 relative to their respective weights in the MSCI ACWI (see chart below). The majority were proportionally underweight with Russia, India and China in particular standing out, the latter largely as a result of foreign investment restrictions.

Between 2012 and 2013, despite clear net outflows across the EM space (many of which have since been reversed), individual markets again defied prediction or pattern, further underlining the pitfalls of lumping such diverse and volatile markets together under an all-encompassing ‘emerging markets’ banner.

In order to get to the bottom of this apparent unpredictability, Professor Karolyi uses regression analysis to identify the main factors driving increased or reduced investment from amongst the six categories. The results, which are discussed in detail in the book, should be an eye-opener for companies in these markets, particularly those with a relaxed attitude towards corporate governance.

The search for a universal model, one which eschews labels and classifications and relies instead on standardised empirical data which tell a full and visual story (particularly in the murky world of emerging markets), should be commended. An HSBC advert currently doing the rounds reads “In the future, there will be no markets left waiting to emerge”. Until that happens, Professor Karolyi’s model provides a useful roadmap to growth and investability for emerging economies and a comprehensive checklist for investors looking across a number of increasingly diverse markets.

A Brief History of Dealing Commission

The practice of investors using their own clients’ trading commissions to pay for research and corporate access has been under scrutiny for some time by regulators in Europe. To better understand the current wave of regulations and assess their impact on the market, it helps to take a step back and look closely at the economic models of both the buy- and sell-side, particularly the evolution of the commission structure. In this blog we will attempt to put the discussion in context and get to grips with how it affects the relationship between the sell-side and their clients on the investment management side.

Fixed Commissions

The era of fixed commissions began with the Buttonwood Agreement in 1792 in which 24 brokers meeting under a Wall Street buttonwood tree agreed to trade with each other using a basic commission rate of 0.25%. Over the years this loosely organised group evolved into the New York Stock Exchange.

The original Buttonwood Agreement housed in American Finance Museum in New York

With no differentiation in price, brokers competed to outdo each other in areas such as research, technology and other non-product related services to win business. These non-execution, ‘soft dollar’ services were ‘bundled’ together with ‘hard dollar’ services paid for separately and explicitly by the fund manager. ‘Bundling’ became standard industry practice.

In the 1950s approximately 25% of trades in the US were executed through brokers by institutional investors. During the 60s and 70s this number rose to more than 75%, giving the small consortium of brokers unprecedented revenues and power, and bringing their activities to the attention of the US regulator, the SEC.

The SEC was interested in 3 main areas:

  • Price fixing: collusion between brokers setting prices

  • High fees: unreasonable pricing

  • Exclusivity: brokers would only trade amongst each other

As a result of the SEC’s investigation, on May 1st, 1975, the era of fixed commissions for stock transactions ended in the US. The same practice was finally abolished in the UK following the ‘Big Bang’ of 1986. However soft-dollar purchase of research and other services continued in both markets.

In the UK, the lifting of restrictions on the amount of international equities investors could hold led to a surge in demand for equity research, corporate access and other services from fund managers.

While soft-dollar services continued to attract the attention of regulators on both sides of the Atlantic, they were generally considered to be fair game in a free market economy. It was largely left to investors to decide whether the commission they were paying was value for money.

1990s

Throughout the late 80s and early 90s the use of soft commission agreements continued to grow. 90s regulation centred more on incremental tightening than structural reform, with much of the focus on disclosure to customers, the obligation to provide best execution and a specific prohibition on soft commission arrangements for certain un-related services.

The Myners Report and the pass-through of broker commissions

A reported delivered by Paul Myners (then chairman of Gartmore Investment Management) in 2011 titled ‘Institutional Investment in the United Kingdom’ addressed the question of bundling and ‘softing’. Myners pointed out that the costs for services provided by the sell-side were not being paid directly by fund managers out of their own pockets, but were being passed through to their own clients (e.g. the pension fund).

The Myners Report prompted action by the FSA (now the FCA) resulting in publication of consultation paper CP176 in April 2013. The report concluded that there was an incentive for fund managers to direct business to certain brokers to obtain additional services, rather than to seek the most favourable trade execution terms for their customers, which the FCA deemed unacceptable.

The Myners review recommended that fund management fees should factor in all additional costs (i.e. for soft services) rather than passing them on to the client, particularly as these additional services directly affect the performance of the fund itself.

Two categories of fees paid to asset managers by their clients

Soft Commission Arrangement vs. Bundled Model

The main difference between the soft commission arrangement and bundled model is whether it is the broker providing the ‘soft’ service, or another third party provider. Under both arrangements, the costs of the services are included in the commission rate (not in the management fee) and are therefore borne by the fund manager’s client and not by the fund manager.

In a soft commission arrangement (prevalent in the US), a fund manager agrees to send trades to a broker and receives, in addition to ‘pure’ trade execution, credits (soft dollars or soft money) which can then be used to purchase services such as research and information, usually from third-party service providers. With a bundled model, the broker offers the additional services (e.g. research or corporate access) themselves.

Commission costs depend on the rates negotiated by the fund manager and the broker, and the volume of trades undertaken on behalf of the pension fund. The fund manager’s client (e.g. the pension fund) has no direct control over either factor.

Soft commission Arrangement

Commission Sharing Arrangements (CSA)

The European unbundling mechanism was the Commission Sharing Arrangement (CSA). In the CSA the execution commission would be retained by the broker handling the trade, while the (larger) non-execution component would be kept on the asset manager’s behalf. As trades accumulated the balance in the CSA account would rise.

How are things looking today

The regulatory debate over dealing commissions that followed CP176 in 2013, has been revived and scrutinised by both UK and European regulators.

In the UK, the FCA’s Policy Statement (PS14/7) published in 2014 created a narrower perimeter for the services and goods permissible under the current regime. The FCA also excluded “corporate access” from the list of services that could be purchased with dealing commission.

In Europe, in late 2014 the European Securities and Markets Authority (ESMA), adopted an equally rigorous approach to the purchase of research as part of the MiFID II inducement provisions. As with corporate access, the message is that fund managers should be paying for research out of their own pockets or charging up-front fees to their clients for the service.

The path from here is perhaps best summarised in last summer’s discussion paper by the FCA:

Overall, we conclude that unbundling research from dealing commissions would be the most effective option to address the continued impact of the conflicts of interest created for investment managers by the use of a transaction cost to fund external research. We believe it would drive more efficient price formation and competition in the supply of research, removing the current opacity in the market. It would be particularly effective if this reform can be achieved on an EU-wide basis.

The final regulations around research continue to be a hot topic and are expected to come into force in Europe by 2017. In addition to the regulatory developments outlined here, other factors such as electronic, off-exchange and intra-buy side trading have continued to eat away at the market share of the traditional broker, resulting in falling commissions and challenging the existing model more than ever.

Sources and additional references:

‘The Myners Report’

Museum of American Finance: Original Buttonwood Agreement

OXERA’s “An Assessment of Soft Commission Arrangements and Bundled Brokerage Services in the UK”

FCA’s Consultation Paper : CP 13/17 Use of dealing commission

FCA’s Consultation Paper 176: Bundled Brokerage and Soft Commission Arrangements

Ashurst’ “New regime for the use of dealing commissions — impact on managers and brokers”

Ashurts’ “Softing and bundling — where are we now?”

Ashurts’ “Dealing Commission: A History”

Investment Management Association: The Use of Dealing Commission to Purchase Research

Frost Consulting

A New Frontier in Financial Technology

This is re-print of a piece that first appeared in Technology Viewpoint in IR Magazine edited by Michael Chojnacki from Closir.

There’s something different about Level39. Europe’s largest financial technology accelerator opened two years ago in the heart of London’s Canary Wharf with the explicit aim of supporting the next generation of technology start­ups. Most of the growing number of entrepreneurs on Level39 left their jobs in the City to try to solve industry problems their employers and competitors had little appetite to address, following the vast reduction in R&D and technology budgets post­ 2008.

Working in small, agile teams and freed from the internal approval process, the next generation are quickly rising to the challenge. This hasn’t escaped the attention of the large banks and sector players, who monitor the market closely, often looking to partner, invest in or buy from the new kids on the block.

Why should we care? Because the technology developed by entrepreneurs in places such as Level39 will play a fundamental role in shaping the IR industry during the next 10 years. It will dictate how shares are traded, cleared and settled. It will influence the composition of shareholder bases. It will govern how we develop and maintain relationships with investors and analysts. It will impact our access to information that helps us to make intelligent strategic decisions. The most relevant areas of innovation can be broadly categorised into six key themes:

  • Fragmentation of Investment Research

  • Technologies in the Capital Raising process

  • Data Science and Analytics

  • Democratisation of Corporate Access

  • Development of Trading Technologies

  • Evolution of Marketplaces and Support systems

Today we would like to address the first topic.

Fragmentation of Investment Research

Before setting up Stockviews, Tom Beevers spent nine years as a pan­ European portfolio manager at Newton, a London based investment manager with over $75bn in assets under management. Like many of his colleagues in the industry, he was a heavy consumer of research but became frustrated with the lack of variety of perspective. As a result he often found himself searching through online forums, blogs and social media for other viewpoints. Seeing an opportunity, he founded Stockviews, an online platform that collects equity research from independent analysts (anyone can write research on any stock) and rates each based on the performance of their past stock picks. This is potentially an interesting development for IR teams. It means that existing sell­side analysts may soon have to make room for the growing number of independent analysts whose views are followed and respected by thousands of followers. It certainly wouldn’t harm IR teams to keep the top­performing analysts on their radar and perhaps even engage in periodic dialogue with them. A fresh perspective can be helpful and innovative ideas like Stockviews are a good way for companies and investors to broaden their horizons.

Wisdom of Crowds

The growing trend towards group opinion platforms is testament to belief in the wisdom of crowds. In 2014 researchers from Purdue University, City University of Hong Kong and Georgia Institute of Technology published Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media. The authors analysed approximately 10,000 articles and comments on a popular social media platform for investors called Seeking Alpha. Its ability to predict stock returns and earnings surprises was much higher than expected, supporting the case for independent research. Others platforms which gather research, estimates, or opinions about listed companies include EstimizeSumZero and Value Investors Club.

Influencers of this trend

Another factor sell­side research teams have to contend with is the new wave of regulation governing payment for research and corporate access services. The proposed EU regulations are expected to severely limit the degree to which fund managers can pay for research out of trading commissions, thus resulting in fund managers having to pay for research out of their own P&L. With investors hesitant to pay out of their own pockets it becomes uneconomical for brokers to cover a long tail of mid and small­-cap stocks. Institutional investors are increasingly setting up their own in­-house research teams, further exacerbating the problem.

In light of the inherent conflict of interest in the current model, the key words behind the latest regulations are ‘accountability’ and ‘transparency’. New market players are increasingly utilising social technology as a tool to level the playing field and democratise the research process. But do social finance platforms have a role to play in the professional investor community? This question was posed at last summer’s annual CFA conference in Seattle. The strong consensus was that online crowdsourcing communities can be very useful, particularly to investors with less access to sell­side analyst reports or those looking for a different perspective. If technology driven platforms continue to make the investment process more efficient and inclusive, they will no doubt become a serious challenger to current industry standards.

The Economist: The Fintech Revolution

This week’s special report in The Economist on Financial Technology (or Fintech) talks about the new wave of ideas changing traditional finance, from payments to wealth management, crowd funding and digital currencies. Fintech start-ups continue to attract record investment year-on-year from the venture capital community, and many are long past the experimental phase. The report also discusses the uncertain and evolving relationship between fintech and traditional banks.

As we have pointed out in some of our previous posts, despite the fact that many of the most relevant trends in this space are still nascent or emerging, there is huge potential for them to impact the asset management industry and subsequently our world of investor relations.

For those fairly new to the subject, you may find our basic Fintech Dictionaryuseful in explaining some basic concepts and definitions.

A few points from the Economist report in particular caught our attention:

  • Although the amount of assets managed by automated wealth managers (so-called ‘robo-advisors’) doubles every few months or so, the global total is still only around $20bn, compared to roughly $17tr for traditional managers. The argument in favour of robo-advisors, which mainly utilise indexing strategies while staying clear of mutual funds and individual stocks, is that they can use algorithms to provide sound investment advice for a fraction of the price of a real life advisor. The majority of the take-up so far has been from clients under 35 with an average account size of less than $100,000. It is interesting to note that Schoders, Goldman Sachs, Vanguard, Schwab and JP Morgan Chase have all either made direct investments in robo-advisory platforms or are planning to launch their own.

  • The electronic ledger ‘Blockchain’ is the technology behind the digital currency Bitcoin. Blockchain offers a decentralised, public account of all Bitcoin transactions. Enthusiasts believe its application in the financial markets may be much broader; in theory the technology could be applied across a wide range of applications, such as the issuance and trading of securities. Unsurprisingly, a number of large financial institutions, as well as exchanges, have taken steps to explore this further.

  • Providing financial services to millions of customers, especially to those in populous emerging markets in Asia and Africa who previously had no access to them, is another area that fintech looks to address. While only 25% of people in Africa have access to a bank account, over 80% have a mobile telephone. Taking advantage of this gap is M-pesa, a Kenyan phone based payments scheme now used by three quarters of adults in the country. As these concepts evolve it is fascinating to think about the possibilities and applications for providing credit, retirement and investment solutions to millions almost overnight.

We will continue look at some of these ideas in more depth over the summer.

Investor's Desktop

Over the summer we spoke to over 50 institutional investors to find out a little more about what tools they currently use on a daily basis in their investment decision process. A portfolio managers desktop would likely include a combination of the following platforms:

  • Financial data providers (for real-time prices, company fundamentals — both current and historic, public filings data, research reports, technical charts)

  • Sell-side analyst support (research reports, recommendations)

  • Screening tools (some through data providers, some internal)

  • Financial news terminals (international and local)

  • News and social media aggregation tools (including RNS)

  • Sell-side analyst consensus consolidators

  • Expert networks (communities of industry professionals on the ground)

  • Macro research tools

  • Portfolio risk analytics and valuation tools

Where does investor relations fit in?

Although the tools listed above provide investors with key fundamentals and perspectives on the company, there are a number of other areas where information that is critical to the investment decision is often more difficult to find. We have put together a checklist that summarises the areas that investors have told us are most important, and where investor relations can make an impact. To request this check list contact any of our team (info@closir.com) and they will be happy to share it with you.

Helping investors to fill in the gaps and reduce the noise is central to what Closir does. Based on the feedback above, we’ve built a simple, standardised template for companies that investors can access easily view, compare and integrate into existing research processes. View your current profile by logging in to Closir.