Over the past four decades, many City of London conventions have been quietly abandoned. Stockbrokers no longer charge fixed commissions on share transactions and insider trading, once an accepted perk of a Square Mile career, is but a memory. Some arcane practices have yet to be discarded, however. Among these is the practice of fund managers charging clients to look after their money and then dipping into customers’ funds to buy the services to do the job.
Regulators are finally taking aim at this quaint custom. The Financial Conduct Authority wants brokers’ research to be treated as a cost to the manager rather than borne by the client - a reform known as “unbundling”. The EU-wide regulator, the European Securities and Markets Authority, takes a similar view. It would like to see the practice stamped out as part of the implementation of Mifid 2, the financial markets directive due to come into force in January 2018.
Yet some fund managers are not waiting for the heavy hand of officialdom. Since January several UK firms have stopped paying for banks’ research through trading commissions - costs that are ultimately born by clients. Instead they are paying for it straight out of their own pockets.
Baillie Gifford, a 108-year old Scottish investment management firm that oversees £110bn of funds, and the £290bn Aberdeen Asset Management both now pay their banks and brokers separately for research and trading. Stewart Investors, an Edinburgh fund, has followed suit and crowdsources research through a website. All three say the change has led to a reduction in costs.
It is not hard to see why this should be so. Investment banks generate vast volumes of research, very little of which is ever read. Of the £3bn spent in 2012 by UK investment managers on dealing commissions, roughly £1.5bn was notionally kicked back in the form of investment reports. Yet fund managers often throw these into the bin without even reading the headline.
This pointless activity has real costs, loading charges on to investors that they struggle to identify, let alone control. For instance Railpen, a £20bn UK pension scheme, took several months to work out that its headline fees were about a fifth of the true cost of its asset management. The compounding effect means that these costs weigh heavily on long-term returns.
It is hard to understand what fund managers are paying for when they assign commissions to investment banks to pay for research. Some argue that they are paying for ancillary services, such as liquidity. The snag is that it is impossible for the underlying beneficial owner to know whether this activity helps their own funds or not.
The existing practice seems little more than a producer racket. Some practitioners have claimed that the research business will be hugely affected if fund managers have to finance the cost themselves. That speaks volumes about the perceived value of the product that investment banks think they are selling. More fund managers should follow the lead given by the pioneering firms. There is no need to wait for the regulators. The industry should be moving to a new model where managers pay all their operational costs from a single charge.
Markets function best when managers spend money only on things they need and pay sensible prices. Gone are the days when fund managers equipped themselves lavishly with products purchased with recycled “soft dollars”. Bundled commissions should follow such practices and be consigned to the unlamented past.