Transparent Alignment in Investment Research: From Unbundling to Relational Contracting

Abstract

Unbundling fees for financial services – e.g., separating payments for third-party research from commissions for trade execution – is in the long-term best interests of institutional asset owners: it can increase both transparency and alignment with intermediaries, such as external asset managers. Yet how unbundling takes place can be a major determinant of when its benefits for asset owners are realized. That is, for asset owners, long-term gains from unbundling can come at a cost of short- term pain – as recent experiences under MiFID II demonstrate. In this paper, we explore paths for increasing transparent alignment between asset owners and their external asset managers over both short and long horizons. We argue that ‘research budgets’ are a crucial tool to this end, because they could support deeper relational contracts between asset owners and managers. We discuss how emerging lessons from MiFID II show a need for institutional asset owners to take a proactive role in understanding not only their asset managers’ spending on third-party research, but also how that research generates value-for-money in terms of alignment with those managers’ intended investment strategies and processes. More participatory research budgeting could also help asset owners’ relationships with their external asset managers in areas beyond research spending, e.g., in better controlling style drift, monitoring ESG efforts, and doing more rigorous performance attribution.