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MiFID II-Created Research Squeeze Hits Activist Shareholders- Industry

Tom Burroughes, Group Editor , 7 August 2018

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A possibly unintended effect of the sweeping EU rules about disclosure of costs and data that came in at the start of this year is that it reduces availability of research in some companies, making shareholder activism more difficult, practitioners say.

There’s a great deal of noise – and increasing action – around the virtues of what is called impact investing or environmental, social and governance-themed (ESG) money management. Investors are encouraged to use their financial firepower to sack incompetent managers, clean up the planet and help the poor. It is hard to avoid the chatter around these issues in finance.

But here is something to note: the ability for shareholders to use that economic clout is in some ways becoming more, not less, difficult. One widely chronicled trend has been the surge in the use of “passive” investment, with the explosive growth in exchange traded funds. Faced by rising regulatory costs and dissatisfaction with benchmark-hugging “active” managers, the bull market in equities has seen a shift towards holding whole indices or sub-sectors of a market. But how can a holder of an ETF push to change the policies of constituent firms in an index? Also, the use of pooled funds means the end-investor is inevitably less engaged with the firms in which they ultimately invest. Another issue is that rising compliance burdens as well as financial shifts have seen a number of listed companies being taken into private hands via buyouts. All such shifts blunt shareholder activism.

Consider this article from the Wall Street Journal (6 January, 2017), there has been a contraction in the number of US-listed firms, contracting by more than 3,000 since peaking at 9,113 in 1997 (source:  according to the University of Chicago’s Center for Research in Security Prices.) In June 2017, the WSJ said that there were 5,734 such public companies, not much more than in 1982, when the economy was less than half its present size.

In Europe, investors have now had seven months of the second iteration of the Markets in Financial Instruments Directive. (According to IHS Markit, the regulations cost about $2.1 billion in 2017 alone.) The framers of which see its push for cost transparency as a way of protecting investors, a most worthy goal. One impact seen even before MiFID II went live was a change to how sell-side firms provide research on companies. The rules effectively make firms unbundle research payments from executions, disrupting how research is done, practitioners say. Industry practitioners also say that it is aready encouraging some brokers to cut research on small- and mid-cap stocks because it is no longer a profitable area – and that is not good for activism, at least in the short-run.

As fund managers have to start doing their own research on stocks, there is a danger of their not knowing from peers – as was the case in the past with sell-side research – whether they were thinking on the right lines, Nick Burchett, of Cavendish Asset Management, told this publication. 

Regulators want users of research to have a much clearer idea of what they are paying for, and that is a positive step, Burchett continued. But the cutbacks in sell-side coverage, at least in recent months, come at a price.

“The fear may be that if you don’t take everyone’s research you could be missing out on some tail in the market,” he said. “You also have to start asking why you own a stock if it is not in your research universe,” he continued. 

A danger might be, Burchett said, that among the less-covered medium- and small-cap stocks, this situation will get more severe; roadshows for firms seeking to list on markets and raise capital could become more onerous, for example. Another issue is that if research reduces overall, this could lead to bid/offer spreads widening on stocks as a function of reduced liquidity. 

“I would also add it is vitally important for investors to engage with management to understand the sentiment, culture and business practices. This is all well and good but management time is limited and this ultimately is a distraction from the day job of running the company,” Burchett said.

But the nub of the problem might also be that active investing could take a hit, he said. 

The MiFID II rules even affect non-European Union firms that trade in European equities or do business in the bloc.

Cooper Abbott, president and chairman of Carillon Tower Advisers, a US-based asset management house, said availability of research coverage of stocks is declining in the UK as a result of MiFID II.

“We are seeing a similar phenomenon in North America driven more by the separation of research from trading, but with similar net results,” Abbott continued. 

On the flipside, if there are under-researched firms, that is eventually going to create tempting opportunities for alpha-chasing investors looking for diamonds amid an increasingly opaque universe, he said. 

“That sets up very interesting opportunities for research-based investors from a longer perspective,” he said. 

“The focus [of many investors] these days has become so short-term.  Patience, an ability to look beyond the most current quarterly earnings, can drive significant returns when combined with original analysis,” he added.

It may well be that developments around AI, for example, may mean researching companies becomes a lot cheaper – and the very fact that some stocks might be under-researched is going to be a great opportunity for investors seeking the “ugly ducklings” that might become a swan. But what appears clear according to some practitioners is that the regulatory landscape is not yet making it easier for investors to analyse firms and change how they behave. One paradox of today is that pressure for transparency that has given us MiFID II and other rules may for some time be at odds with modern ideas about investing for impact. To put it another way, one of the effects of such regulations highlights that age-old truth about the "law of unintended consequences".

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