A central tenet among investment managers is to act in the best interests of their clients. There are many people, however, including regulators from the Financial Conduct Authority (FCA), who think that the widespread practice of dealing commission with respect to equity markets is undermining this core principle.

Under current rules, set out by the Financial Services Authority (FSA) in 2006, investment managers are allowed to charge clients for a defined range of execution or third-party research services as part of the dealing commission.

Guy Sears, Director at the Investment Management Association (IMA), who has worked in close collaboration with the FCA on dealing commission, explains: “The FSA was right to be worried. Because the manager gets the benefit of research but the customer pays the cost of it, there is clearly a risk of misaligned incentive. There is a risk therefore that people will over-purchase, or put trades for research purposes rather than best-execution services.” Currently, an estimated £3bn is spent per year on dealing commission in the UK, and around half of that is thought to purchase research.

However, as FCA Chief Executive Martin Wheatley set out in a speech in October 2013, the regulator is still concerned, and cites two persistent problems: “Firstly, services are being ‘bundled’ together, with eligible and non-eligible services being mixed. Secondly, when this information is provided back to the client, there is a lack of clarity or adequate transparency around how their commissions have been spent.”

As an example of bundling, the FCA found that some firms allocate significant sums of their Bloomberg and Reuters subscriptions to dealing commission, only some of which could reasonably be classed as legitimate research. Further still, a significant stretch of the definition of research includes payments to brokers for corporate access – where investment managers can meet and talk to the executives of the companies they may invest in. In 2012, an estimated £500m of dealing commission was spent on corporate access – about £100,000 per investment manager.

Splashing the cash

As set out in its recent paper, ‘Consultation on the use of dealing commission rules’, the FCA is concerned that investment managers are far more liberal in paying brokers for ‘research’ out of the dealing fees paid by clients than they would if it was their own money. In response, it is trying to ensure that investment managers seek to control the costs to clients when paying for research with dealing commission.

New ideas on research

 i. clarifying the criteria for research goods and services that can be purchased by investment managers with dealing commission paid from customers’ funds

ii. defining ‘corporate access’ and adding specific guidance on the treatment of corporate access for the use of dealing commission

iii. providing guidance on making mixed-use assessments where investment managers purchase bundled brokerage services that contain both research and non-research elements, or would have been commissioned if investment managers had to pay for them using their own funds.

To Christopher Bond, Chartered MCSI, Senior Adviser to the CISI, the paper shows a clear move to regulation from encouraging market-led changes, looking at the buy-side in investment managers, and the sell-side formed by brokers. “The FCA is looking at what can be charged and moves the pendulum, questioning the assumption that a payment can be shifted on to the client, except under narrow rules,” says Bond.

In revisiting the definition of research (see box, New ideas on research), as set out in the Conduct of Business Sourcebook 11.6, the FCA is seeking to clarify what is legitimate for the purposes of charging under dealing commission and what is not – the litmus test is that research must be ‘substantive’ and yield meaningful conclusions rather than simply provide information from which investment managers can make their own decisions. Notably, the new proposals exclude payment for access.

Understandably, market participants are feeling nervous. “The paper worries many. On the sell-side there are fears that the buy-side will not buy research,” says Bond. On the buy-side, he adds, there are fears that the charge for research may come entirely out of the managers’ Annual Management Charge (AMC). “The direction of travel can be seen by media and political criticism of poor transparency of ‘hidden’ management expenses, and concerns that overall investment fees and expenses are too high – estimated at a third of pension ‘pots’ when savings are already too low. It is no longer unusual to question who should pay transaction commission. The Government has also proposed capping the AMC level in its automatic pension scheme.”

Whereas some sections of the industry fear the incursion of the FCA into the market, others claim that the regulator is not going far enough. Gina Miller, Co-founder of SCM Private, firmly believes that all payments for research should be made from the AMC.

“What you are effectively getting in charging research costs under dealing commission is double payment,” she says. “What are you paying fund managers for if not to conduct their own research, or pay for the research they outsource?”

Economies of scale

According to Sears, there are advantages to buying ‘off-the-shelf’ research from brokers, most of which are large banks. “What the banks have is economy of scale,” he says. “It just doesn’t make economic sense for an investment management house to cover the thousands of equities for sale on world markets. But the larger banks, which offer brokering services, have the resources.”

Therein lies the rub. According to Sears, the reason the FCA is looking at the sell-side is that a lot of research is not available to buy separately from the brokering service. In turn, this means that many investment managers buy research that is tethered to execution. “It stands to reason that if investment managers have to access the research through paying within the brokering services, they will go that route in order to look after their clients,” he says.

So do the FCA’s plans suggest that brokers will one day become execution-only? Sears thinks not. “Obviously good, legitimate research has some economic value to the investment managers,” he says. “Why would they stop providing research? Do they believe they would be paid less money? Demand might mean that managers tighten up their budgets, but if research brings value, someone will do it.”

The possibility, says Sears, is that as post crisis, a cohort of bankers responded to regulation by going away and setting up their own hedge funds, the industry may see a blossoming crop of boutique research houses selling just their own research. If this happens, then the debate about whether research should be paid out of dealing commission may move on.

The True and Fair Campaign

In response to what they see as extortionate pricing structures and collusion in the UK’s investment management market, Gina and Alan Miller, Co-founders of SCM Private, set up the True and Fair Campaign in 2011. The campaign is geared towards providing better information for retail customers, giving them a clearer picture of the fees they pay and a means to compare the prices of different investment firms.

A key component of the campaign is the True and Fair Investment Calculator, which aims to show clients the cost of investing, taking into account the charges that investment management firms typically impose. Launched in May 2013 with the help of several founders and partner organisations, it is thought to be the first calculator of its type in the world.

While a free version of the calculator creates a back-of-the-envelope breakdown of the effect of some simple charges, the advanced pay-for calculator factors in the full gamut of fund manager charges (from initial charges to performance fees), platform/stockbroker costs, product/wrapper charges and adviser charges.

Any profits earned go to support small charities in the UK that work towards financial education, as well as those that provide care and support for the elderly.

The calculator has proved so popular that the True and Fair Campaign has won the hearts of MEPs, who in October 2013 voted in favour of a similar tool for across the European Union.

It is thought that investment managers, brokers and other intermediaries would be asked to provide data for the tool, which sources suggest could sit on the website of the regulator in each European country. If the legislation is passed later in 2014, the European Securities and Markets Authority will work closely with the True and Fair Campaign to develop a standardised tool.

To find out more, visit trueandfaircalculator.com