The impact of Mifid II (part II): Research
The Edison paper first examined in part one of this special feature finds that Mifid II has had a significant impact in shaping the equity research system ‒ and will continue to do so.
The report sees a number of key developments in the short term and suggests that the content universe available to asset managers will increase, which will open up the competitive research landscape significantly. ‘The traditional mechanism of trading is breaking down, which will lead to growth in independent research,’ says Neil Shah, director of research at Edison Investment Research.
The report notes that revenues generated from securities trading will continue to be separated from payments for investment research services. Michael Hufton, managing director at ingage, a corporate access and IR software company, adds a qualification to this point: ‘I agree – with one amendment: the word continue.’
His point is that execution can be separated from research payments currently, but it doesn’t have to be. ‘Bundled execution and research commission rates are still fairly common, and rates that bundle corporate access with either execution or research spend (or both) are almost universal,’ he says. ‘Under Mifid II firms must separate all these out; bundling will no longer be possible. This is a major departure from current practice.’
Edison also points to a continuing reallocation of spend among research providers with a commoditization of pricing for average producers of research. ‘I would go further,’ declares Hufton. ‘[I would say] a lot of the research market is currently characterized by over-production and a misallocation of resources.
‘We should see the market become much more efficient and effective. Logically, this low-quality commoditized product and the providers producing it will disappear and we will see specialization and concentration on particular fields of expertise. The new structures should create an environment that encourages new, independent providers to come in.’
Edison notes that consolidation on both the buy side and sell side will continue as the buy side moves to produce more of its research input in-house, in effect paying for it from its own P&L.
‘By any standard the buy side in particular is a very fragmented industry,’ says Hufton. ‘We know from the Financial Conduct Authority’s asset management market study that there are 1,787 asset management firms in the UK – an extraordinary degree of fragmentation given the economies of scale in asset management. In some strategies, such as small cap, there are capacity constraints, but for the vast majority of funds investing in large, liquid companies this isn’t the case.
‘Sell-side consolidation is more complex. I think it will happen, but it might well be along more functional lines. For example, there is a strong case for a smaller number of highly automated, highly efficient, low-cost-flow operators to emerge and dominate execution. Specialist research shops will also come together.’
Some of the larger investment banks may flourish in a more competitive marketplace and niche players will be able to command a premium for equity research, but mid-sized providers are likely to be more at risk of going out of business or being taken over as a result.
Against this backdrop, Shah says companies will need to adapt their approach to investor communications and allocate more resources to investor activities. ‘Strategic targeting of investors should become a priority as a concentrated buy side will present a greater challenge and companies should diversify their shareholder bases beyond institutional fund managers,’ he concludes.