The directive has, along with other forces, squeezed research and hit liquidity in small- and mid-sized stocks, which isn't positive for the overall functioning of the market, a report says.
Economics has more than its fair share of “laws” but whatever the changes in ideas over the decades, one that appears immutable is that if you force firms to change how they pay for services, you can get less of those services - at least for a while.
Six years ago, the UK introduced sweeping measures to improve the standard of professionalism in wealth management advice, making fees more transparent and cutting out old commission-driven practices. The Retail Distribution Review entered law and, with the predictability of an English batting collapse at cricket, some wealth advisors began to hike their investment minimums, creating what was called an “advice gap”. Barriers to entry into the wealth advisory market went up and access went down. The jury is still out over whether investment service access in general is better than before 2013.
And now we have had MiFID II as law of the land for just over a year. This European Union regulation – overlapping with RDR in some ways - thudded onto the desks of wealth managers last January. Along with the GDPR regulation, it was one of the heaviest compliance challenges in years. One of MiFID II’s features was a requirement for firms to unbundle research payments. The net effect of this has been to make firms think twice about older ways of buying research, and the sell-side’s offerings have shrunk significantly.
This squeeze on research hits liquidity not just in the smaller-cap stocks, where the cost of coverage has always been a bit of an issue, but even into the medium end of the market-cap spectrum. Declining liquidity, shown in wider bid/offer spreads for prices, may also discourage firms below a certain market cap to list on public markets, which is not ideal for activist investors (a point this publication has made before).
A research report by the Qualified Companies Alliance and brokerage firm Peel Hunt highlights the problem. The study, called MiFID II: The Search For Research, notes that in its survey of 102 UK-based fund managers and 105 small- and mid-cap firms, 62 per cent of investors said that less research was produced on such firms since the European directive became law. Some 86 per cent of investors expect there to be fewer broking houses in the next 12 months.
The report’s language is restrained but bleak: “Generally, the feelings about the impact of MiFID II appear to have worsened since last year. The majority of the investor community have seen their list of research providers decrease over the past 12 months, and only expect further reductions in the future.”
There may eventually be workarounds, as investors exploit a less efficient market to make returns, encouraging more resources to follow. Capital, like water, finds its own level. And firms seeking to woo investors are already looking at different touch points. The report found that 90 per cent of firms are acting or plan to develop websites to make themselves more visible to investors. Respondents say actions such as holding a “capital markets day” is an effective way to improve visibility – so we can expect more such events in future. Some 61 per cent of firms say that they are using more PR to win media coverage – no doubt we journalists can expect the volume of traffic in our direction to rise if this proves correct.
MiFID II certainly has not won many friends yet from asset managers. Some 45 per cent of those managers say that they are “quite negative” on the directive and 21 per cent are “very negative”. Against that, 21 per cent said that they had “no strong feelings” and only 12 per cent could say that they were “quite positive”, the Peel Hunt/QCA report said.
What more general conclusions can we draw from all this? Firstly, if regulations that are designed to make firms more open about their fees and costs are desirable, while this sounds as controversial as motherhood and apple pie, people should be careful. Secondly, policymakers should be more willing to carry out cost/benefit analyses of such regulations and be less in a hurry to prove that they are “doing something” about this or that perceived problem.
It would also be remiss not to consider the Brexit angle. Much has been made of the frictional costs that the UK will suffer if it falls out of the European Union without some sort of trade deal on or close to 29 March. But it should also be borne in mind that there are those in Parliament and a section of the commentariat who worry about the costs of leaving the EU but such complaints are hard to take seriously considering how much EU red tape there has been. Let’s hope that however the UK leaves the EU, policymakers in Westminster look harder at calls for regulation, and test if it makes end-clients better off.