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By Ian Spittlehouse, Alphametry

Ian Spittlehouse

Ian Spittlehouse

The impending MiFID II deadline has sparked fierce debate around how investment research should be priced and paid for. We’ve seen a range of pricing options from the sell side, along with industry speculation on how boutique and mid-tier providers will fare against larger investment banks. On the buy side, most asset managers have said they will not be passing on the cost of research to clients. Notably, BlackRock revealed it would be footing the bill for research, an announcement which quickly saw a number of firm backtracking on earlier decisions to pass these costs onto investors including Schroders, Janus Henderson Investors, Union Investment and Invesco. So what’s missing from this picture?

So far very little has been said about how firms are or will be evaluating research to inform pricing and budgeting decisions. Similarly, the buy side needs to establish whether the research that they purchase is substantive or risk breaching MiFID II regulation. This new requirement for robust evaluation should be welcomed, after all,the investment research market has been crying out for innovation for some time. MiFID II will mean that research becomes a commodity in its own right;it will be bought and sold just like any other commercial product and should therefore be subject to rigorous assessment. The problems firms face is not just how to evaluate, but what to evaluate and how to use the resulting data.

Why evaluate?

MiFID II stipulates that all firms must have a clear methodology around how they pay for research before they receive and consume services, including the setting of measurable, ex-ante criteria on how they will value the types, level and quality of service.Additionally, firms should have agreements with research providers in place prior to receiving substantive services, with pricing being a natural part of these negotiations – any ex-post variation in payments made to the research firm based on actual services received should be made in a proportionate and predictable manner based on measureable criteria. MiFID II also specifies that firms must evaluate services using qualitative and quantitative frameworks consistently across providers, and that regular assessments of research consumption should be conducted to evaluate future procurement decisions and research payment levels.

In the past, regulators have granted unofficial grace periods to firms facing new regulation and this is likely to happen when MiFID II takes effect in January 2018. However, Buy-side firms have to show they have documented procedures and proper records from the outset.

Evaluation process

Research evaluation should take place at several points. Prior to purchase, users’ requirements need to be gathered and used to develop a product specification. Providers have historically been selected for their execution services rather than research, causing providers which did not offer execution to beside-lined. Unbundling will enable the buy-side to consider research from a much wider range of suppliers and should help them match products to their requirements more accurately. This primary evaluation should be revisited on a regular basis to ensure that there is no specification creep, especially in terms of regulatory obligations.

The purchased research should then be reviewed on a regular basis. This evaluation should be multifaceted, not only grading quality in terms of user satisfaction and adherence to the product specification, but also for the comparison of similar products in the market place. This can only be achieved if evaluation data is shared. Today’s post-purchase appraisal can then become part of tomorrow’s pre-purchase discovery.

How to evaluate

A new method of evaluating investment is needed. The much denigrated Broker Vote system’s limitations are well documented, including a lack of granularity, bias against new or niche providers, favouring of large institutions, the list goes on. MiFID II signals the end of a system which dictates that ratings set price after consumption. The new legislation requires prices to be set beforehand, forcing the separation of evaluation from cost. Any new evaluation methodology will therefore need to focus solely on rating the quality of research products.

The new system of evaluation must be flexible, transparent, objective and easily adopted in order to be successful. Flexibility is a pre-requisite as the evaluation model will have to cope with research in a range of different formats. Whilst the majority will be written reports, other formats such as meetings, phone conversations and video could be significant enough to require evaluation. Adopting a standard methodology will be beneficial to all research stakeholders – consumers will use ratings as a guide for purchase decisions, and producers will adapt their offerings according to the feedback received.

Transparency will also be necessary to fulfil regulatory requirements and to give credibility. It is, however, difficult to achieve if an overall, at-a-glance grade is the first visible score. To solve this problem, primary and secondary grades should be layered so that users can drill-down through the primary grade to the component labels and ratings. The number of ratings should be clearly visible, as should the categorisation of the product.

Objectivity is essential but will only be achieved once there is sufficient evaluation data to ensure that outlying scores do not cause distortion. This is only possible if the rating data is shared and consolidated.

Finally, ease of adoption should be considered. Several major firms have rating models that are more complex than a simple five- star system, yet have become widely used by diverse groups of customers. That said, an evaluation should not take more than a couple of minutes, and the rating system should be simple, clear and easy-to-use.


To find the perfect evaluation model, the financial services industry may have to look outside of itself for inspiration. Global companies like eBay, Uber and Airbnb are successful because of their rating systems. In general, their complexity is proportional to the cost of the product. Uber uses a rudimentary five-star grading with optional labels, whereas eBay and Airbnb are more sophisticated. A simple system such as Uber’s is adequate given the low price of the service in absolute terms. eBay and Airbnb use more complex systems combining a primary, overall rating with secondary ratings on specific aspects of the services or goods provided.

Full-service global coverage from a bulge-bracket bank may cost up to $10,000 per user, per year. Given the significant cost, it is clear that a one-dimensional grading model is not suitable for research. A derivative of the model used by eBay and Airbnb could form a sound basis for rating research, as the multiple layers will enable consumers to grade the various criteria that will form part of such an evaluation method, including a ‘substantivity’ test as implicitly required under MiFID II.

The problem with many grading systems is that they eventually become profligate – drivers with Uber ratings below 4.6, and private sellers on eBay with ratings below 98.4 struggle to do business. As there is no vetting prior to admission – anyone can offer their services or products – the rating system itself filters out less performant offerors over time. This is inefficient because the range of scores becomes so narrow that it is impossible to distinguish between the great and the good. This may not matter when choosing a taxi as the prices from different drivers will be the same, however, it becomes very important when two offerings for a similar product. European Equity Research for example, may well have a large price difference.

Ideally, consumers will be able to purchase research from a trusted marketplace where all the offerings have met certain standards prior to their inclusion. This will both save time and ensure that the scores are graduated enough to identify differences. When combined with price and precise coverage information, research buyers will have real choices based on a large number of objective ratings – participation in most commercial grading models is optional, not so for research.

What to evaluate

Another issue is deciding what should be evaluated. Some discussions have concluded that evaluations should only be made at the analyst or even firm level. This is a mistake, as such an approach will have little granularity and will not cope with the huge changes to the industry that are likely to follow MiFID II. As research becomes a significant cost, consumers will demand more choice. For example, socially-conscious or green funds will only want to buy research on equities that match their eligibility criteria. Other factors such as geography, sector and size may not be relevant. Unless individual research reports have been evaluated, it will be nigh-on impossible for the green fund managers to select the appropriate research using measurable and objective criteria.

Analyst- and firm- ratings can be extrapolated from the ratings given to individual units of research, providing that firms performing evaluation using a standardized methodology and agree to share results – doing so on a strictly anonymous basis make the most sense.

The four tests for ‘substantivity’ set out in the FCA handbook are eminently sensible and should be at the heart of any evaluation method. They include adding value to investment decisions via new insights; representing original thought and not repeating what has been said before, having intellectual rigor and not stating the obvious and having meaningful conclusions based on analysis.

The easiest way to incorporate them is to use a model that combines labels and ratings. Labels work by enabling the evaluator to rapidly provide feedback that is richer than a grade on a linear scale. Such labels are grouped together as responses to a question. Ratings, on the other hand, provide criteria of common interest to most potential assessors that are graded on a linear scale (typically 1-5 stars).

Meaningful evaluation

The research industry is going through radical change and this will accelerate post-MIFID II. A new evaluation methodology is needed and will have a variety of applications. Initially ratings will be made post-purchase, primarily for regulatory reasons. As the amount of data grows, and providing results are shared, it will become an important tool in pre-purchase decision making. It will also be used to measure performance internally, and help solve the old problem of to make or to buy, as many buy-side firms expand the own research departments to reduce costs.

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