Incentives are often overlooked as a key issue in behavioural finance; attention is focused on emotion and thinking as biases. But behaviour can be greatly influenced by relatively small changes in incentives.
Moves in reward or cost can trigger surprising shifts in how people view decisions. This might prove to be the driving force for stock market changes under Mifid II.
Most managers, it seems, will take research costs onto their own P&L, with clients benefiting from lower commission rates. Administering client research budgets whilst treating customers fairly was always going to be a challenge, threatening to suck up disproportionate effort and cost.
For most investment managers, the sums involved are not huge in relation to overall administration costs; the shift to absorb research was easily made. But it does seem to be forcing a radical change in thought process.
We will soon find out if this impacts overall trading volumes much, but turnover has already been declining for years. A collapse in activity is unlikely. Nor does it seem likely that the new regulation will simply shift costs from one place to another. Instead, it has made asset managers re-think their whole approach to research.
In theory, creating a client account for research expenditure, combined with much better data on usage, could have improved the management of research. But this process would have been gradual.
Clients to date have shown little interest in Level 1 and Level 2 disclosures of research expenditure. Managers would not have been directly incentivised to deliver better value from research for investors.
Now, the reality of immediately taking ownership of all this cost has very quickly focused the attention of investment managers. Change seems likely to accelerate, cutting costs and radically altering how research money is spent.
It seems much less likely that this will simply favour scale; the biggest bulge bracket investment banks initially looked like winners, but are now nervous.
They are starting to look at it the way their clients do. The investing institutions have quite a different perspective on research when real money is involved, rather than just dealing commissions.
Much of the research of the largest investment banks is focused on listed companies, maintenance research and macro-economic data. But, this is an area where value is harder to prove – there is undoubtedly an excess of research coverage for the mega caps.
And many of the investment banks have remarkably similar offerings. Does that economic research make money for investors? There were few investment banks who got the great financial crisis right, spotting the risk in financial and mining stocks.
Many investors have concluded they need specialist data sources for this. It might be useful to have the services of three or four major investment banks, but not 10.
It is in this large cap area that passive funds are making most inroads. Over many years, the FTSE 100 has underperformed the FTSE Mid 250 index, encouraging investment managers to look further down the capitalisation scale.
Fund managers are concluding that the major investment banks offer beta research, but their own business models are about delivering alpha for investors. We can expect some consolidation of research from these biggest providers.
There has been a pattern in recent weeks of investment banks initiating research or making calls on mid cap and stocks further down the FTSE 100. They now realise that alpha is what sells best.
And, the most surprising change has been that some major investment managers – including Fidelity, Alliance Bernstein and Allianz GI – plan performance fees on funds.
Amidst the headlong rush for scale and indexation, it seems that active managers know there is performance to be had in parts of the market, and will buy research accordingly.
Moving the cost of external research from one pocket to another will re-engineer the industry in unexpected ways. There is nothing like the feeling that you are spending your own money to concentrate the mind.
Citywire A-rated Colin McLean is founder and director of SVM Asset Management. His UK Growth fund, run alongside A-rated Margaret Lawson, has returned 40.8% over three years versus a peer average of 28.3%.