Independent Equities Research is the new Black

3 January 2018 is the starting date for Europe’s far-reaching new legislation for financial markets, called MiFID II. Included in the 28 articles of this EU Directive are new rules for fund managers and stock brokers regarding payment for equities research.

From January 2018, no longer can trading commissions, paid by investment funds to stock brokers, be used as blanket payments for execution, research and the corporate access services these brokers provide. Instead, fund managers will need to breakout these costs separately as broker services need to be unbundled. Additionally, fund managers will need to pay for research from their own P&L, not the fund's P&L.  

MiFID II will be game-changer for equities research

As the costs of equities research will need to be broken out as a separate line item from January 2018 onwards, we expect fund managers will scrutinise the quality of research much more closely.

For instance, fund managers may only be willing to pay for research from the top 3 analysts on a particular stock, with the rest of the analysts potentially being perceived as adding too little value to pay for. Therefore, we anticipate declining numbers of research analysts on the back of MiFID II, resulting in less research coverage of listed companies.

MiFID II is coming to a market near you !!

Despite being a different jurisdiction than the EU, Australia is not immune to MiFID II. Many global fund managers with EU branches are already implementing best practices dealing with MiFID II in their branches globally, including Australia!

Similar to Commission Sharing Agreements (CSA’s) that originated in the UK and have come to be used in financial markets globally, we expect MiFID II will become one of the EU’s major export products in the next few years driven by investment funds with a branch or head office in the EU, which includes many US, Asian and Australian funds.

So, while the Australian regulator, in its upcoming new guidelines, may not want to introduce restrictions similar to those in the EU, which would potentially result in less equities research coverage of ASX-listed companies, we expect the Australian funds management industry will self-regulate, i.e. fund managers with an EU presence are required to implement MiFID II anyway, while other managers may want to adopt certain MiFID II best practises, including the practises around payment for equities research.

Implications for ASX-listed companies

The bottom line is that over the next several years we expect a decline in the number of research analysts that will be available to cover ASX-listed companies, even for Mid and Large Caps stocks.

As an example, the current 22 analysts covering Telstra are unlikely to each add an equal amount of value to fund managers’ investment processes. As a number of fund managers start to pay for research out of their own pockets from January 2018 onwards, we expect the increased scrutiny regarding added-value of research reports to result in declining revenues from a particular stock for brokers that are not in, say, the top five research providers on that stock.

Of course, brokers tailoring to retail and sophisticated investors will require research on Telstra for their segment of the market, but longer term, in the aftermath of MiFID II implementation, we believe 22 analysts covering Telstra will turn out to be too many.

A barren research wasteland at the small end of town

Going forward, we expect Mid and Small Cap companies will find it increasingly difficult to get their messages out to the investment community. Already, research coverage in this market segment is very limited and mainly driven by one-off events, such as capital raisings. With the number of research analysts dwindling over time, we anticipate brokers will have even less capacity available to provide research coverage for this market segment over time.

Enter the independent research providers

Unbundling of broker services has been on-going in Europe for many years and has led to the emergence of an entirely new class of equities research, i.e. independent research providers, with the UK being the furthest developed in this respect. Business models for independent research vary and include company-commissioned research as well as subscription-type models in which fund managers pay a fixed fee to receive research from a specific independent research provider.

While independent research is a relatively new phenomenon in Australia, we believe the tailwind from developments such as MiFID II and the already limited research coverage of the Mid, Small and Micro cap segments of the ASX, bodes very well for this newly emerging class of equities research in the local market.

Sector specialisation is key

We expect this segment in Australia to mostly develop along the lines of sector specialisation and expertise, where in-depth sector knowledge and a strong background in sector coverage will be the building blocks for a successful independent research provider.

Listen to our interview on the implications of MiFID II on the equities research landscape in Australia HERE.