Institutional investment managers are tightening their commission wallets for the third year in a row due to a prolonged slump in U.S. equity trading volumes, and sell-side firms are feeling the pain.
Those are some of the takeaways from a Greenwich Associates U.S. Equity Investors Study released today, which reported that commissions paid by U.S. institutional investors to brokers on trades of domestic equities declined six percent from Q1 2011 to Q1 2012. As a result of the trading slowdown and contraction in the equity brokerage commission pools, institutional spending on sell-side equity research and advisory services fell to $6.2 billion for the year, from $6.8 billion in the prior 12-month period.
According to the Greenwich study, the $10.86 billion in total U.S. equity brokerage commissions paid by institutions last year is the lowest amount reported since 2007.
This is not a surprise since U.S. equity trading volumes have been 6.5 billion shares this year, as compared to 8.5 billion a few years ago. Also, retail investors have pulled their money out of the stock market and headed into bonds or zero interest bank accounts, and the problematic Facebook IPO has encouraged their fears.
A story in the New York Times on Tuesday talked about how the technical glitches and losses suffered by retail investors in the Facebook IPO have made investors more fearful of the stock market. The percentage of households invested in U.S. equities, whether directly or through mutual funds or exchange traded funds, has fallen every year since the financial crisis, reaching a low of 46.4 percent in 2011, from a high of 53 percent in 2001.
However, the unexpected shortfall in equity brokerage commissions is complicating life for the buy side which needs to pay for research and other critical sell-side services.
With the contraction of their equity brokerage commission pools, the buy side paid 56 percent of the equity brokerage commissions were allocated to research/advisory for the year ending Q1 2012, an uptick from 55 percent in the prior 12-month period. If the buy side devoted 56 percent of their commissions to research and other advisory services, then at least 44 percent was allocated to pay for executions including high touch trading and low-touch electronic trading using algorithms and analytics such as TCA. The commission squeeze has already had repercussions for sell side firms, claims Greenwich. In response to the revenue shortfall, several of the sell-side brokerage firms are cutting back on headcount, consolidating trading desks, scaling back coverage and otherwise reducing the level of resources devoted to U.S. equities, notes Greenwich in its analysis of the study, adding that smaller brokers and regional brokers are feeling the most heat.
So what is the outlook for the commission picture going forward? Well, based on this study, the picture isn’t too rosy. Greenwich suggests it may be difficult to reverse the U.S. equity commission pool shrinkage. Citing evidence from its study, the firm said about a quarter of large institutional investors interviewed for its 2011 Investment Management Study said they planned to make significant reductions to their active domestic equity allocations by 2014 and 16 percent planned sizable reductions in passive U.S. equity allocations. In both areas, only 3-4 percent of institutions planned significant increases.
“The bottom line is that the entire industry — investors, brokers and other equity research providers — should be preparing to operate in an environment in which there are fewer commission dollars to spend,” says Greenwich Associates consultant Jay Bennett. “The sell-side is already moving to adjust their businesses to this new reality.”
But investment managers and other institutional investors have no choice but to compensate the sell side providers of research and advisory services since their portfolio managers and analysts rely on these services for their investment decisions. In a sense, paying for research is a fixed cost that the buy side cannot forgo.
If the commission pool which has been steadily shrinking for the past three years, continues on that track, institutions will be compelled to use a “bigger portion of their overall commission amounts to cover the research chit,” asserts consultant John Colon, in the firm’s release. This in turn could put pressure on sell-side trading desks to ration their services more. No doubt, buy side traders are already adapting their trading styles in the wake of the weaker volumes. Already, some buy-side firms have changed their trading behavior, one sell side source told me recently.