European regulators should carefully consider the impact of proposed “unbundling” regulations on the quality and availability of equity research, according to new research from Greenwich Associates.

Any decline in research quality or availability could affect the performance of institutional investors, Greenwich warns.

Unbundling requires firms to pay for investment research directly, rather than through the traditional method of allocating trading business to reward good research.

Greenwich reports that European institutions paid out more trading commissions in 2004 than they did in 2003, owing in large part to a 23% increase in total equity assets under management. But investors held the line on average commission rates, at 18 basis points.

“The 18 bps average equity commission rate paid by European institutions for the past two years is comparable with that paid by institutional investors in the United States and other markets,” says Greenwich Associates consultant Jay Bennett, “and as is the case all over the world, the growing use of electronic and portfolio trading could drive average rates lower still. Many European institutions expect to further increase their use of electronic and portfolio trades, which suggests to us that there will be more downward pressure on average commission rates in coming months.”

The firm says that these low commission rates have prompted some equity brokers to take a new look at the profitability of their business and begin rationalizing their resources in research and, in some cases, sales coverage.

This strategic reassessment is occurring in virtually every major equity market covered by Greenwich Associates around the world. In Europe however, the effects of this process could be exacerbated by proposed “unbundling” regulations, which could have widespread consequences for brokers, buy-side institutions, and independent providers of equity research.

“As regulators act to ensure that investors are getting best execution on their equity transactions, they should carefully consider the market-wide impact of any new unbundling rules,” says Greenwich Associates consultant John Webster. “Our research suggests that consistent declines in commission rates have reduced trading costs to a point at which their impact on institutional investment performance is miniscule. But a reduction in the quality or availability of the equity research that institutions use to inform their investment decisions could potentially have a real effect on performance.”

“Regulators in all European markets are rightly concerned with ensuring that the end investor is not paying excessive trading commissions,” says Greenwich Associates consultant John Colon. “But our research illustrates that due to a variety of factors — including the growing use of low-cost electronic trading and portfolio trading — the impact of trading costs on investment performance is diminishing. These findings raise the question of whether the promised economic benefits of unbundling will be enough to offset some potential negative consequences to small institutional investors and independent providers of equity research.”

The research also finds that institutional investors are placing as high a value on sell-side research as ever. Buy-side institutions are also displaying their desire for quality equity research in one other way that may reflect some concern over the quality or availability of broker research: they are hiring analysts for their own in-house staffs and expect hiring to remain strong through the coming year. However, it is important to note that large institutions are much more aggressive than their smaller counterparts in both their current hiring and future staffing plans.

“By bringing more research in-house, institutions are betting that it will lead to improved performance and ultimately sufficient additional assets under management to counter the additional cost,” says Bennett. “With investors’ own margins under pressure, it is a difficult bet for larger institutions to place and a nearly impossible one for smaller investors. Regulators need to consider how any new rulings with the potential to make it harder for the buy side to access good outside research will affect the investment community. Our research suggests that such regulation would have a disproportionate impact on small institutional investors that lack the resources to maintain significant sized internal research teams. Surely it is not the intention of regulators to disadvantage the little guys relative to large institutions and hedge funds.”