A sell-side survey revealing discontent among fund managers over the detrimental effect of Mifid II on analyst research has drawn buyside criticism claiming that the industry was already “over brokered” and that small-cap companies “do not have a divine right to be covered”.
According to a Peel Hunt report, a majority of fund managers surveyed said Mifid II had a “detrimental” effect on research quality and demand and liquidity for small and mid-cap stocks. Two thirds of the 102 fund groups surveyed said less research is being produced in the small and mid-cap space.
“The unintended consequences of Mifid II that we have seen so far are just the beginning,” warned Steven Fine chief executive of Peel Hunt.
But the investment industry is not unanimous in its criticism of the rules requiring research costs to be unbundled.
“There was arguably always too much sell-side research,” says Dan Brocklebank, director at Orbis Investment Advisory. “At least from our perspective, far too much of it was focused on short-term news flow and so was of very little value.”
Brocklebank is not alone in his defence of the EU directive, which came into effect on 3 January 2018.
Research of value is worth its fee
Daniel Godfrey (pictured), ex-chief executive of the Investment Association, says “it’s a bit rich” for the industry to be complaining about having to pay for their own research when the FCA gave them ample opportunity to address problems with the old system.
The fact that the industry has responded to assuming the cost of research by buying half as much as they used to is telling, Godfrey thinks.
“Clearly, if research has value you should either be willing to pay for it out of your fee or by telling your clients why they should be paying for it,” says Godfrey. “If it doesn’t add value, it should disappear.”
While the current regime “is not ideal” and has likely had unintended consequences on the quality or availability of research, he stresses changes needed to be made.
“There may be less research but then most people would say the market was over-brokered and there was too much research particularly on the larger companies,” he says. “And if there’s a hiatus of research on smaller companies I think it will eventually be rectified because it’ll mean there’s a gap in the market for it.”
‘Small companies do not have a divine right to be covered’
Peel Hunt found that seven in 10 investors said their access to research providers has decreased as a direct result of Mifid II with over half stating they are worse off because of it.
Peter Sleep, 7IM senior portfolio manager, says it is more likely the medium sized companies that will suffer the most if analyst resources are diverted to covering FTSE 100 companies and other large cap stocks. That said, he says he hasn’t noticed any fall in liquidity as a result of Mifid II.
On the sell-side the second-tier banks and brokerages have been hit hard by Mifid II, says Sleep. Independent economic research houses could also come under pressure, he says.
Sleep says buy-side firms could face even more pressure to trim their research lists if volatility continues. “It is bad enough now, just think how bad it will get if we have a 50% bear market,” says Sleep.
However, Sleep says “small companies do not have a divine right to be covered,” noting that many were not followed by analysts pre-Mifid II.
“It was always the case that coverage was focused on large cap firms at the expense of small and Aim listed entities, Mifid just made it worse,” agrees Gavin Fielding, editorial director at Fundscape. “Realistically research is going to be focused where it is most profitable for a research firm so large caps and interesting growth sectors.”
Regulatory casualties
One anonymous respondent in the Peel Hunt survey said Mifid II is “a net negative for all involved in the industry,” creating “huge compliance and expense burdens while contributing nothing to transparency”.
“Mifid II has significantly reduced the amount of research brokers produce, the number of companies they cover and brokers’ ability to interact with fund managers,” they said.
“Many brokers have become execution-only or only cover a small number of high-liquidity securities. Fund managers are left with only their in-house views rather than having their analysis challenged by several external parties. The effect is to concentrate investment in fewer large caps as research cannot be obtained on a more diverse group of companies. And more mistakes are made in investing as fund managers have few relationships left that can challenge their views.”
Fielding says he has noticed a big reduction in the number of reports being issued and firms providing coverage, as well as the number of analysts conducting the research.
“Anecdotally it seems that some firms have seconded research staff on to other things or combined roles. Free research has all but vanished and firms tightened up what could be viewed based on who was allowed to see content under Mifid.”
Brocklebank agrees that “even the pockets of quality long-term research are suffering at the moment”.
UK fund managers will also experience their fair share of pressure, with most firms agreeing to take a hit to their profit and loss (P&L) account in order to cover research costs. Only a small handful of asset managers agreed to pass on the costs of external research to clients.
Mispricing opportunities
Several commentators have argued that thinning out the number of brokers and investment banks producing research will lead to better mispricing opportunities for active investors prepared to do their own due diligence in the small to mid-cap space.
Jason Hollands managing director of Tilney says: “When parts of the market are under researched it creates both challenges and opportunities. As chunks of the stock universe become under-researched or progressively ignored from a fundamental perspective because of the shift towards passive investment, this ultimately is going to impair market efficiency, undermining the price discovery process.”
Anomalies in the most liquid parts of the market are already usually priced in, he says, but active managers have more room to hit on small-cap gems before the wider market catches wind.
Fielding agrees markets could become less price efficient. “This does open up opportunities for some fund managers to do their own research or maybe start investing in research to pick out value stocks.”
But Sleep says most investors that have hit upon small-cap gems have done so without the aid of sell-side coverage. Trendy tonic water Fevertree was generally ignored by analysts until its share price started climbing. “The analysts all jumped on board after it rose 10 times.”
He says sell-side analysis will rarely challenge a manager’s own view as most sell-side reports are ‘buy’ reports anyway.
“Why would a broker challenge a buy order from a client? In my experience the best push back comes from within my own firm, wherever I have worked in the past.”
