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John Greenwood: Time for investment managers to come clean on research costs

For all the noise around charges, you would think it would no longer be possible for fund managers to make their AMCs and TERs look lower than they are by hiding costs off balance sheet through soft commissions.

But that is precisely what is happening when fund managers use soft commissions from brokers to build up slush funds to buy research without it appearing on their P&L.

Most people would think the money spent by fund managers on research to help with stock selections would be reflec­ted in the fund’s annual management charge. Some of it is – but not all.

Fund managers can pay dealing charges either on an execution-only basis or with research bundled into the cost of trading.

When stocks are traded with research bundled in, the broking investment bank does not pay for the research there and then. It holds the money until the fund manager decides which research organisation it wants the money to go to, at which point the broker pays the organisation for the research.

What kind of way is this to do business? If a fund manager wants some research done they should pay for it directly, rather than rack up portfolio turnover charges off balance sheet – not affecting the AMC or TER at all – to swell the slush fund.

The Investment Management Association has effectively ad­mit­ted that fund managers operate in this way to reduce head­line costs. As an IMA spokes­woman told me last month: “The pension funds won’t allow the managers to raise their charges above a certain point. The pension fund knows they are paying for the research and the quid pro quo is that the fee is not high. It is the same cost.”

Credit to Standard Life as one of the few finance houses to come clean on this cost. It says of around 13 basis points paid to brokers for trading, around half go to pay for research.

Paying for research through commission is not illegal. Back in 2005 the FSA reviewed so-called soft commissions and while it prohibited certain forms of deals it allowed payment for research through soft commissions to continue.

However, the regulator recent­ly expressed concern at the perverse incentive created by this loophole in the regulation. In its November paper on the subject – Conflicts of Interest Between Asset Managers and their Customers: Identifying and Mitigating the Risks – it expressed its displeasure that fund managers did not exercise the same stan­dards of control over research bought through commission as they did on research bought with their own money.

If this money is genuinely being spent on essential research, why should it not be shown as a balance sheet cost of running the fund?

The new joint industry code of conduct on charges goes some way to addressing the problem of portfolio turnover charges, but even this will not show how much of those charges is going into a fund manager’s research slush fund. To be fair to the new code, soft commission is a slightly different argument, but it is a shame the code does not cover this hidden cost.

The FSA needs to rethink the exemption for soft commissions for research. The debate on charges has moved on since 2005. Auto-enrolment has brought higher demands for transparency and pension providers have largely done their bit to raise their game.

Most fund managers refuse to disclose their research costs paid through soft commission. It is time they came clean.

John Greenwood is editor of Corporate Adviser


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