Asset managers face
profitability pressure:
The implications of Europe’s research unbundling for Asset
Managers
October 2016
Analytical contacts
Suprabha AD
Senior Director, Global Head of Research
CRISIL GR&A
[email protected]
Abhik Pal
Director, Global Financial Research
CRISIL GR&A
[email protected]
Table of contents
Executive summary .............................................................................................................................................. 4
Research unbundling, a snapshot ........................................................................................................................ 5
European active managers to face substantial margin pressure ........................................................................ 6
US AMs would see a much lower impact .............................................................................................................. 8
Navigating the unbundled world .........................................................................................................................10
Executive summary
Research unbundling to be implemented in Europe by January 2018
The European Commission has approved the Markets in Financial Instruments Directive II (MiFID II), which will
be implemented by January 2018. A key provision of MiFID II pertains to research unbundling, which will have a
profound impact on how research 1 will be funded, assessed and paid for. Under the present soft-dollar regime,
asset managers (AMs) pay sell-side firms for research largely through trading commissions, the costs of which
are eventually borne by investors. However, under MiFID II, AMs are required to either absorb research costs or
set up a research payment account (RPA), the cost of which can be borne by investors but entailing additional
disclosure, budgeting, reporting and audit requirements.
Operating profits of European AMs could fall by 17-29%
Over the past few years, active AMs have been facing many challenges such as falling fees and increasing
preference of investors for passive products. However, their operating margins have remained resilient at about
30%, driven by cost control and growth in assets under management due to capital appreciation. However, we
believe research unbundling will significantly affect AMs margins. Under our base-case scenario, operating
profits of European active AMs would decline by 17%, assuming exposure to equities would be 35% of total
assets under management and AMs’ research spending would fall to 80% of current spending, driven by prudent
research consumption and better negotiation with brokers. Under our bear case, operating profits will decline
by 29%, assuming that AMs have a higher exposure of 40% to equity and research spending remains 100% of
current levels.
US AMs would not be insulated either. At a minimum, they would have to implement unbundling for their funds
registered in Europe, although the impact on profitability is likely to be modest initially. However, we expect
unbundling to be introduced eventually in the US too, as pressure would increase on the country’s regulators
once MiFID II is implemented in Europe and investors benefit from lower costs. The ensuing impact on US AMs’
operating profits could be more material, falling by 9-16%.
How we see European AMs responding
It is unlikely that European AMs will adopt a uniform strategy to address the challenges. However, we expect
the following:
1. Research cost of AMs will fall as they budget their requirement better
2. Most large AMs will opt to absorb research costs, rather than go through the strenuous process of setting
up RPAs
3. AMs will choose specialists for execution and research
4. AMs will optimize their research procurement mix by leveraging bulge-bracket brokers for their breadth of
coverage; boutique/regional firms for their differentiated insights; and third-party service providers for
bespoke research and as an extension of their onshore teams
5. There will be a greater thrust on technology and outsourcing as AMs look to reduce margin pressure
1
Research includes allied services such as corporate access and advisory
Research unbundling, a snapshot
MiFID II to be implemented by January 2018
In April 2016, the European Commission approved the Markets in Financial Instruments Directive II (MiFID II),
more than five years after it was initially proposed in December 2010. The European Commission has delayed
the implementation of the directive by a year to January 3, 2018, taking into account the technical
implementation challenges faced by regulators and market participants. The directive requires the full
unbundling of research (including allied services such as corporate access and advisory) from trading
commissions, among the various measures to improve the functioning of financial markets and make them more
transparent. The delegated acts under MiFID II, which cover inducements in research, is a directive rather than
a regulation that is universally applicable to the whole of Europe, and hence European countries will have to
pass individual legislation to adopt their own version of MiFID II by July 3, 2017.
Big impact on research sourcing, funding and payment strategies
Under the present soft-dollar regime, AMs pay sell-side firms for research through trading commissions, the
costs of which are eventually borne by investors. The higher the trading by AMs, the higher the commission
available for their research spending.
Under MiFID II, broker-dealers can provide only non-substantive research, such as short-term market
commentary or company results with no substantive analysis, without any monetary consideration. European
AMs have to pay for all other research requirements by either 1) paying out of their own P&L, or 2) setting up a
research payment account (RPA) that can be funded through a pre-defined charge to investors or an enhanced
commission sharing agreement (CSA), i.e. the existing CSA arrangement with greater transparency and audit
requirements.
Notably, the directive allows the continued use of CSAs, a partial relief to AMs, which feared that CSAs would
be prohibited altogether. This would make it marginally easier for those AMs who choose to pass on research
costs to investors, albeit with a more operationally challenging process and with greater disclosure levels. To
illustrate, AMs would have to agree on the research budget with clients beforehand.
Key differences before and after unbundling
Before unbundling
Research budget 
Research
funding and
payment

After unbundling
Linked to trading volumes – the higher 
the trading, the higher the commission
pool available for research spending
Mainly through CSAs
AMs have to establish research budgets at the start
of the year; trading activity will not influence
research spending

Through P&Ls of AMs

Through RPAs, which can be funded through
‒
Specific pre-defined charges to investors
‒
Enhanced CSA (audit trail, better disclosures)
Assessment of
broker research
quality

Use of broker vote to share feedback
on research quality

Establish robust quality criteria to assess the
standards of research purchased and its linkage to
better investment decisions
Reporting
disclosures

No disclosure of third-party research
costs to clients was required

Ex ante – agree on the research budget with clients

Ex post – disclose the actual research spending
Source: CRISIL GR&A
Individual European countries to interpret and adopt MiFID II
Individual member-states can accept the EU Directive ‘as is’ or set even more stringent standards. On
September 12, L’Autorité des Marchés Financiers (AMF), the French regulator, released its consultation paper
which provided guidance on equity research unbundling. AMF has endorsed the use of commission-sharing
agreements (CSAs) to fund RPAs. It has also provided flexibility in budgets in terms of allocation (budgets can
be made at an investment firm level and apportioned at a fund level) and tenure (budgets can be made on a
‘multi-year basis’ rather than annually).
On September 29, the Financial Conduct Authority (FCA), the UK regulator, released its consultation paper on
the implementation of research unbundling rules. The guidelines are relatively more detailed and stringent
compared with French guidelines. For instance, the guidelines require the recipients to assess whether the
research they have received is substantive or not. If it is substantive, the recepient has to either pay for it;
otherwise, it can refuse to accept the same. While CSAs have been allowed, the research charges have to be
swept to an RPA immediately and should be ring-fenced. It does not allow for budgets to be set on a multi-year
basis. Further research related to fixed income or other non-equity instruments is also subject to these rules.
European active managers to face substantial margin pressure
AUM growth, cost control sustain margins despite headwinds
Over 2010-15, the net fee margins of active AMs in the US and Europe fell sharply, driven by competition from
low-cost passive products. However, an analysis of ten large active AMs in both the regions 2 indicates that they
have been able to maintain high operating margins of about 30% over the past few years, driven largely by an
increase in AuM on capital appreciation (implying higher revenue from fund management fees) and effective
cost control (rationalisation and outsourcing).
Growth in AuM supports income, offsetting lower fee
margins
Base FY10=100
160
35%
+47%
140
+24%
120
-23%
100
-9%
80
60
Operating margins of large AMs remained largely
stable over 2013-15
30%
25%
AuM
Net Fee
Margin
AuM
Europe
FY10
Net Fee
Margin
US
FY15
20%
FY10
FY11
FY12
Europe
FY13
FY14
FY15
US
Source: Bloomberg, company filings, CRISIL GR&A. The analysis is based on 10 large active AMs in US and Europe. Net fee margin is
computed as net asset management income divided by average AuM. Operating profit margin corresponds to the profitability of the asset
management operations
The 20 large active AMs in the respective regions were selected based on the 500 largest AMs 2015 raning provided by Towers Watson. We have considered
AMs for which financials were available in public domain. For Europe, the analysis is based on the asset management divisions of Allianz SE, Axa Group,
Deutsche Bank AG, BNP Paribas, UBS AG, Prudential PLC, Legal & General Group PLC and traditional AMs: Amundi, Natixis and Schroders PLC. For US, the
analysis is based on the asset management divisions of JPMorgan Chase & Co, Goldman Sachs Group, Prudential Financial, Northern Trust Corporation, Bank
of New York Mellon Corporation and Ameriprise Financial as well as traditional AMs: Franklin Resources, Invesco, T Rowe Price Group and Legg Mason. We have
excluded passive managers including BlackRock, State Street and Vanguard.
2
Operating profits of European AMs could fall 17-29%
Active AMs, which are losing their AuM share to passive AMs, are under increased scrutiny from investors to
justify their high fees given their failure in consistently outperforming benchmarks. According to S&P3, only
about 14% of active funds in Europe outperformed the benchmark over the 10-year period ending 2015. In
Europe, the share of passive assets in equity funds has also sharply increased by 600 bps to 23.2% over 201015, according to Morningstar.
We believe that research unbundling requirements will add to AMs’ woes in this challenging environment. We
have performed a pro-forma financial analysis of the ten large active AMs in Europe as a proxy to assess the
impact of unbundling on European AMs’ profitability under three scenarios (bull, base, and bear). We have used
the three scenarios to estimate current research costs (using assumptions for the equity proportion of AuM and
portfolio turnover). We have then assessed the impact of research unbundling on AMs’ profitability.
As we think most large AMs will prefer to absorb research costs rather than set up an RPA, we quantify the
impact on profitability based on the various assumptions related to the extent of research costs that would be
absorbed.
Key takeaways

In our base case, operating profits of the large European active managers could decline by around 17%,
assuming that AMs incur 80% of current research costs related to equity AuM (assumed to be 35% of total
AuM).

We estimate that operating profits could decline by about 29% in the worst-case scenario, in case AMs have
a higher exposure to equities (40%) and end up incurring 100% of current research costs.

In the optimistic scenario, operating profits could decline by only around 9%, assuming a lower equity
proportion (30%) and only 60% of current research costs.

We expect that the impact on smaller AMs, which do not enjoy the scale benefits of larger players, to be
higher.
Impact on profitability could be higher if:

Active funds continue to lose share to passive funds and the fee margin continues to deteriorate.
The impact of unbundling on other asset classes such as fixed income and multi-assets is factored in: At
present, buy-side firms do not explicitly allocate research costs related to fixed income (FI) transactions,
but the costs are implicitly built into the bid-ask spread. However, under MiFID II, FI commissions would
also need to be unbundled.
Impact on profitability could be lower if:

AMs negotiate research costs effectively with their sell-side or independent research providers and
rationalize their research consumption more than expected.

AMs are able to reduce the average transaction commission by increasingly leveraging on automated or lowtouch trading.
3
SPIVA Europe Scorecard (2015): % of European equity funds that beat S&P Europe 350
Impact of unbundling on profitability of large European active AMs
Research cost estimate
Bull
Base
Aggregate AuM (€ tn) [A]
8.7
8.7
Estimated equity
component of AuM (%) [B]
30
35
Portfolio turnover4 (%) [C]
Bear Assumptions
Aggregate AuM of 10 large European AMs. The selected AMs are largely
8.7
into active funds although they have some passive exposure as well
We believe that the equity portion of the AuM will be most affected by
unbundling. Among large AMs, we observe that traditional AMs have a
higher exposure (40%-60%) to equity/balanced products, while
40
diversified institutions (insurance and investment banks) have a lower
exposure (15%-25%) to equity/ balanced products. We assume average
equity AuM to be 35% in our base case.
Based on external studies and our own analysis, we observe that large
equity funds with a focus on value and investments in large-caps have
55 a lower turnover (40%-60%) and mid-sized equity funds with a focus on
growth and investment in mid- or small-caps have a higher turnover
(80-130%). We assume a turnover of 50% in our base case.
Bear Assumptions
45
50
Research cost estimate
Bull
Base
Implied traded value (€ tn)
[D] = [A]*[B]*[C] *2
2.3
3.0
3.8
Estimated equity bundled
commission rate (bps) [E]
12
12
12
Estimated allocation
towards research (%)[F]
45
50
55
1.3
1.8
2.5
Bull
Base
Bear Assumptions
30.4
30.4
30.4
8.7
8.7
8.7
1.3
1.8
2.5
Implied equity research
costs (€ bn) [G] =[D]*[E]*[F]
Pro-forma financials
Asset management income
(€ bn) [H]
Pre-unbundling operating
profits (€ bn) [I]
Implied equity research
costs (€ bn) [G]
Research costs likely to be
incurred by AMs (%)[J]
Post-unbundling operating
profits (€ bn) [K] =[I]-[G]*[J]
Change in operating profit
(%)
60
80
100
7.9
7.2
6.2
(8.7) (16.8) (29.0)
Total traded value has been estimated to include both the sale and
purchase value (i.e. twice the portfolio turnover).
We assume that AMs will pay the commission rate on the entire traded
value. The prevailing high-touch all-in equity commission rate is around
15bps and high-touch execution commission rate is around 7bps in
Europe5. We assume a blended rate of 12bps.
It is estimated that institutions currently allocate 50-60% of their total
commission pool toward research, advisory, sales and corporate
access services6. We assume allocation of 50% in our base case.
Aggregated FY15 financials of the asset management divisions of the
ten large European AMs
Operating profits correspond only to asset management operations;
OPM of the AM operations estimated at 30% for FY15E.
We believe that most large AMs will choose to absorb research costs
rather than set up RPAs. In our base case, we assume research costs of
AMs would be 80% of current research costs, driven by prudent
research consumption and better negotiation with sell-side firms.
Operating profits of European AMs could decline by 17-29% after
unbundling in our base- and bear-case scenarios.
Source: Bloomberg, Company filings, CRISIL GR&A
US AMs would see a much lower impact
US may eventually follow suit
The current US legislative framework is not favorable to unbundle research and execution costs. Under the
Securities and Exchange Act, US brokers cannot receive direct payment for research unless they register as
Turnover definition as prescribed by SEC
Accenture – Trading Commissions: Rising Above the “Race to Zero”
6 Greenwich Associates – European Equities under attack from all angles
4
5
investment advisors in the US; they are not inclined to register as investment advisors given the ensuing
restrictions to trade on a principal basis. However, US AMs would still have to implement unbundling for their
European operations from January 2018. We expect the US market to eventually implement unbundling, as
investors benefit from lower costs in Europe and pressure grows on US regulators to follow suit.
Impact of research unbundling on profitability of large US active AMs
Research cost estimate
Bull
Base
Bear Assumptions
Aggregate AuM ($ tn) [A]
10.0
10.0
10.0
Estimated equity AuM (%) [B]
30
35
40
We assume equity AuM to be 35% in our base case.
Portfolio turnover (%) [C]
45
50
55
We assume a turnover of 50%, similar to that in Europe.
Implied traded value ($ tn)
[D] = [A]*[B]*[C] *2
2.7
3.5
4.4
Estimated equity commission rate
(bps) [E]
10
10
Aggregate AuM of 10 large US AMs. The selected AMs are largely
into active funds though they have some passive exposure too.
10
We assume that AMs will pay the commission rate on the entire
traded value. The prevailing high-touch all-in equity
commission rate is around 12bps and the high-touch execution
commission rate is around 6bps in US3. We assume a blended
rate of 10bps.
It is estimated that institutions currently allocate 50-60% of
their total commission pool toward research, advisory, sales
and corporate access services. We assume an allocation of 50%
in our base case.
Estimated allocation towards
research (%)[F]
45
50
55
Implied equity research costs ($
bn) [G] =[D]*[E]*[F]
1.2
1.7
2.4
Pro-forma financials – unbundling
of entire AuM
Bull
Base
Bear Assumptions
Asset management income ($ bn)
[H]
52.8
52.8
52.8
Aggregated FY15 financials of the asset management divisions
of the ten large US AMs
Pre-unbundling operating profits
($ bn) [I]
15.2
15.2
15.2
Operating profits correspond only to asset management
operations; OPM of AM operations estimated at 29% for FY15E.
Implied equity research costs
($ bn) [G]
1.2
1.7
2.4
Research costs likely to be
incurred by AMs (%)[J]
60
80
100
Post-unbundling operating profits
($ bn) [K] =[I]-[G]*[J]
14.5
13.9
12.8
Change in operating profits (%)
(4.8)
(9.1)
(15.8) Profits of US AMs could decline by 9-16% after unbundling.
Pro-forma financials – unbundling
of European AuM
Bull
Base
Bear Assumptions
Exposure to European AuM (%) [L]
20
30
40
Implied Research Costs - Europe
($ bn) [M]=[G]*[L]
0.24
0.52
0.96
Operating profits (post
unbundling)] [N] =[I]-[M]*[J]
15.0
14.7
14.3
(1.6)
(3.4)
(6.3) Operating profits of US AMs could decline by 3-6% after
unbundling.
Change in operating profits (%)
Source: Bloomberg, Company filings, CRISIL GR&A
In our base case, we assume research costs of AMs would be
80% of current research costs.
In our base case, we assume that European AuM could
represent 30% of US AMs’ Equity AuM.
Key takeaways

Although the US regulations do not currently mandate research unbundling, US AMs would still have to
implement MiFID II on their European operations. We expect the US to also eventually implement
unbundling, as pressure would grow on the country’s regulators once MiFID II is successfully implemented
in Europe and investors benefit from lower costs.

Based on our estimates, operating profits of US AMs could fall by a modest 3-6% in our base and bear cases,
assuming that unbundling is implemented only for European operations, which are assumed to account for
30-40% of total AuM.

However, once AMs eventually implement unbundling in the US too, the impact could be more meaningful
at 9-16%.
Navigating the unbundled world
AMs are still deliberating on how to respond to research unbundling. Individual AMs are likely to respond
differently, depending on their size, country of operations and competitive pressures. Based on our discussions
with our AM clients, we see the following trends emerging:

Research spending across AMs to reduce: Irrespective of whether individual AMs decide to absorb research
costs or continue to pass them on to investors, we believe AMs will be more discerning in the research they
purchase. We expect research spending of the overall European AM industry to decline as research costs
are separated from trading commissions and AMs negotiate harder with investment banks.

Most AMs, particularly large ones, likely to absorb research costs: We believe that most AMs, particularly
the larger ones, will absorb the research costs, rather than adopt the strenuous process of setting up RPAs.
Early adopters in the UK have already chosen to absorb costs. For example, Baillie Gifford, an Edinburghbased asset manager that manages US$120bn, began absorbing research costs fully as early as January
2016. Woodford Investment Management, with $12.7bn in assets under management, followed suit in April.
As more AMs take this approach, we believe the remaining AMs will come under significant pressure to
absorb research costs. A few AMs have attempted to raise the fund management fee to mitigate the impact
of absorbing research costs – Legal & General Investment Management (LGIM) started paying for research
from April but increased management fees by 4 to 15 bps across funds. However, we believe AMs will find it
difficult to increase their asset management fees meaningfully due to competitive pressures.

AMs to choose specialists for execution and research: According to Greenwich Associates, US AMs use 3560 brokers for research/advisory services and 40-60 brokers for equity trading with significant overlap– we
consider the figures as reasonably representative for the European market as well. In the research
unbundled world, we believe AMs will look choose specialists for execution and research.

AMs to optimize their research procurement mix (in-house/in-house with third-party, sell-side, or IRPs):
Against the backdrop of research unbundling, we expect AMs to optimize their research procurement mix.
We believe AMs will leverage bulge-bracket brokers for their breadth of coverage, mid-sized and regional
brokers for differentiated and in-depth research, and third-party providers for bespoke research and
coverage expansion of peripheral universe. We expect AMs to continue depending on bulge-bracket brokers
for other allied research services such as corporate access.

Greater thrust on technology and outsourcing as AMs attempt to offset margin pressure: New technology
investments will be required to implement research unbundling. For example, investments may be required
to set up RPAs and to assess, track, and evaluate third-party research. We also expect AMs to increasingly
outsource to third-party service providers, across research, sales and marketing, operations, risk and
compliance, to limit the pressure on profitability.
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