[ I N - D E P T H
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I N V E S T M E N T
R E S E A R C H ]
T
he endeavours of Europe-
an regulators to introduce
greater transparency of
costs and charges - to the ulti-
mate benefit of end investors
- via MiFID II has been harder to
realise than policymakers may have
anticipated. The unbundling of re-
search and execution payments is a
central part in this bid for transpar-
ency. But rather than bringing costs
of trading to the light, critics argue
that the rules have had little impact
on transparency, reduced research
coverage and quality, and even
dented liquidity of certain stocks.
For the buy-side, the way in
which businesses source, consume
and pay for research has been
turned on its head as a result of
unbundling. The rules mean that
asset managers can no longer
accept research that has been paid
for through execution commissions
and, after years of preparation, the
majority of buy-side firms have
opted to absorb those addition-
al expenses rather than passing
them on to the end investor. With
“The squeezed research houses are
putting their efforts into the larger
liquid stocks, rather than the lower-
ticket small caps which are typically
more difficult, and now more
expensive, to analyse.”
MICHAEL HORAN, HEAD OF TRADING,
BNY MELLON PERSHING
the cost of research now directly
impacting company P&L, research
budgets across the buy-side have
plummeted as attention shifts
towards profitability.
66 // TheTrade // Spring 2019
A report on the impacts of unbundling from CFA In-
stitute early this year found that larger buy-side firms
are making the biggest cuts to budgets. On average,
research resources have declined by around 6.3%, but
for buy-side firms managing more than ¤250 billion,
budgets have fallen at a higher level of around 11%.
Research quality is also perceived to have taken a hit
since the regulation was introduced according to both
buy- and sell-side participants surveyed by CFA Insti-
tute, as 44% of sell-side respondents indicated a drop
in quality, although only 27% of buy-side respondents
believed that was the case.
As sell-side institutions and research providers
compete for these smaller budgets, coverage in less
liquid stocks has also suffered. CFA Institute’s report
found that very few respondents perceive an increase
in research quality or coverage of those stocks under
the MiFID II regime. Half of both buy- and sell-side
market participants agreed that coverage of small- and
mid-cap equities in particular has dwindled. The long-
term unintended consequences of this is expressed as
a major cause for concern across the industry.
Michael Horan, head of trading at BNY Mellon
Pershing, says that the impact of unbundling on sell-
side research, as well as the exodus of research ana-
lysts from sell-side institutions, was well-documented
throughout 2018. But the most troublesome of un-
bundling’s consequences is the emphatically reduced
liquidity across small- and mid-cap equity markets.
“Expenditure on small-cap research has decreased
significantly, and coverage per company at the smaller
end of the market has declined accordingly,” Horan
says. “The squeezed research houses are putting their
efforts into the larger liquid stocks, rather than the
lower-ticket small caps which are typically more diffi-
cult, and now more expensive, to analyse. This creates
two problems: much lower liquidity at the smaller
end of the market – which we are seeing already – and
more capital into large-cap stocks. This, combined
with the broader shift to passive investments and
continued inflows into ETFs and index tracker funds,
is artificially increasing prices and causing investors to
herd into large-caps.
“Lower liquidity in small and mid-caps has a number
of potential implications. During periods of market
volatility, such as the correction seen in ‘Red Octo-
ber’ in 2018, it makes it more difficult for traders and
investors to unwind positions in what was previously a