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 don’t 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. At Odyssean, we would argue that this brings opportunities as well as challenges for equity managers – notably those active in the small-cap space.
Go with the flow
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. 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. A survey by the CFA Institute in early 2019¹ confirms this, showing asset manager research budgets had fallen on average 6.3% since the introduction of MiFID II with research from investment banks particularly hard hit, a trend that many expect to continue through 2019 as managers continue to assess their needs.
Making an impact
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 investor relations team and announced headcount reductions at firms such as Berenberg indicate the shake out is beginning; we believe it is likely to accelerate.
With reducing headcount inevitably we would expect the quantity and quality of research to suffer. The Quoted Company Alliance Mid and Small Cap Investor Survey for 20182 showed that 48% of market participants felt that the level of small and mid-cap research had fallen post MiFID II and 45% expected the quality of research to decline further going forward.
The more-subtle impacts of MiFID are how it changes the behaviour of market participants. Firstly, sell-side analysts are now working in an environment much more focused on evidencing they are paying their way. This in turn increases pressure on analysts to produce research with strong views – after all who pays for research with a hold recommendation. Secondly, we are seeing a decrease in freedom of interactions between buy-side and sell side. Anecdotal stories of asset managers refusing to leave voicemails for the sell-side for fear of incurring a charge are not representative but do point to a reduction in the freedom of market conversation which was key to the investment process for many small cap managers. Finally, the change in distribution model under MiFID is impacting the very notion of there being a ‘market consensus view’. With all research no longer being freely available to all there is no longer a single consensus view on stocks (especially notable for small caps with limited coverage). This can drive a fear of asymmetry of information around small-caps and in turn a reluctance to trade.
With change comes opportunity
These changes, reducing quantity, quality of research and reduced market consensus all of which flow from unbundling will, in our view, exacerbate many of the traits of small-cap stocks. These are namely that poor coverage and market knowledge drives lower liquidity, which drives greater volatility and in turn more mispricing potential – and in this there lies opportunity. Any change which drives more potential mispricing is good news for active managers, provided they have the strategy and skill set to benefit.
In a small cap market where broker research coverage and depth are reducing, managers who do not rely on sell-side research to drive their investment decisions have an advantage. The skills to drive independent research, drawing on strong networks of experienced individuals are invaluable in finding the information edge that allows better pricing of risk and reward in opaque markets. Furthermore, we would argue that lower liquidity and greater volatility are likely to be increasing features of the small cap market. In themselves these too present opportunities.
We believe irrational volatility is a potential investment opportunity for the patient manager and that a long-term investment horizon paired with long-term, patient capital can achieve superior returns in this illiquid sector.
MiFID II has been in place for 18 months and we believe the impact of the changes it will bring are only beginning to be seen. The major market dislocation some feared has not yet come to pass, but the cascade of changes driven by regulation are affecting the small cap market. Active managers with the right investment strategy and skill set should be excited by the impact of MiFID II and embrace the change and opportunity it brings.
Source 1 CFA Institute report “MIFID II: One year on – Assessing the Market for Investment Research” https://www.cfainstitute.org/-/media/documents/survey/cfa-mifid-II-survey-report.ashx
Source2 QCA / Peel Hunt Mid & Small-Cap Investor Survey April 2018 – https://www.theqca.com/membership/pdf.php?path=/article_assets/articledir_286/143286/QCA_Peel_Hunt_Mid_and_Small-Cap_Investor_Survey_2018_Email.pdf&br=FreeNonMemberDownload&sci=143286
About Ed Wielechowski
Ed joined Odyssean in December 2017 as a fund manager. Prior to joining Odyssean he was a Principal in the Technology team at HgCapital. He joined HgCapital in 2006 and worked on numerous completed deals, including multiple bolt-on transactions made by portfolio companies. He has additional quoted market experience having led all aspects of the successful IPO of Manx Telecom plc in 2014 as well as having evaluated and executed public to private transactions. Ed started his career as an analyst in the UK mergers and acquisitions department of JPMorganCazenove in 2004.