Change is the lifeblood of equity markets.
The twists and turns of geopolitics, the tides of technological change and the swings of the business cycle all present opportunities for savvy asset managers to create value for their clients.
Managers should love change for this reason, however there is one area where change gets consistently poor press, where change is commonly viewed as a burden and not an opportunity: regulation.
When it comes to regulatory change, things do not get much bigger than the roll out of MiFID II in January 2018.
The impact of these regulations on financial markets has been profound and continues to evolve.
I would argue that this brings opportunities as well as challenges for equity managers – notably those active in the small-cap space.
The key impact of MiFID on equity markets has been to change the flow of information between the sell-side, who produce research on stocks, and the buy-side, who ultimately evaluate stocks and make investment decisions.
Research on small caps
For small caps where information was already less available, the impact of this change is marked.
The move under MiFID to ’unbundle’ how asset managers pay for research from trading fees - historically research being provided ‘free' with the expectation that trading volume would be channelled to brokers in return – was designed to increase transparency and protect clients from conflicts of interest.
However the ripples from this change, and its unintended consequences, are beginning to impact how market participants interact.
The move to more clearly priced research has inevitably led to asset managers putting increased scrutiny on what they pay for and how much they spend.
Anecdotal evidence and survey results show that 2018 saw a period of price discovery with asset manager spend significantly undershooting broker expectations.
- MiFID II has had a huge impact on the research of small cap stocks
- Research is less predictable around small cap stocks
- This creates buying opportunities for fund managers
A survey by the CFA Institute in early 2019 confirms this, showing asset manager research budgets had fallen on average 6.3 per cent since the introduction of MiFID II with research from investment banks particularly hard hit, a trend that many expect to continue as managers continue to assess their needs.
Greater transparency on pricing and spend failing to meet expectations has revealed the strained economics of research production for the sell-side.
It is our expectation that MiFID II has shown many research teams to be drags on group profitability.
Headcount reductions are inevitable as brokers look to match costs to a small and reducing revenue base.
This effect is likely to be focused on smaller and regional brokers who are less able to subsidise research from other areas of business, impacting the small-cap market where these firms typically focus.
We have already seen several high-profile analysts leave small cap brokers to join the buy-side or corporate IR team and announced headcount reductions at firms such as Berenberg indicate the shake out is beginning; we believe it is likely to accelerate.