The European Union's MiFID II regulations have reduced the quantity and quality of small- and midcap equity research, making price discovery in the sector less efficient and creating opportunities for active managers to add value, sources said.
Among other things, the Markets in Financial Instruments Directive II requires brokers to set a price for investment research apart from trade execution services. Money managers doing business in Europe now must either charge their clients for the research or pay for it themselves.
Research on small- and midcap equity, which in Europe ranges from companies with a market capitalization of between £100 million ($111 million) and £7 billion, in particular, has dropped in volume after the regulation took effect in January 2018, as brokers turned their focus away from this broader and less efficient market, sources said.
A recent survey of 102 fund managers by advisory and execution firm Peel Hunt LLP found that 62% of investors said less research is being produced on small- and midcap equity stocks since MiFID II took effect. And a survey of 496 professionals conducted by CFA Institute, also published in February, reported that 26% of buy-side respondents said small- and midcap equity research quality has declined, and 30% said the cost of small- and midcap equity research has increased.
Sixteen percent of respondents in the CFA survey disagreed that research costs decreased and 26% disagreed that the quality of research decreased.
Eoin Murray, head of investment at Hermes Investment Management in London, said: "The coverage of small compa- nies has (been) reduced." And because "the price discovery is less efficient, it creates opportunities for managers to add value," he said.
With most managers choosing to absorb the cost of obtaining the research externally and with fewer external players having the capacity to uncover alpha in small-cap equity, the value of in-house research of active small-cap managers is going up, sources said.
Brokers are covering the small-cap market more selectively because they can't monetize research to the same extent as before MiFID II. And money managers said they can find better-performing companies in sectors such as aerospace, industrials or general retailers, where the research gap has been the most pronounced, by scouting financial reports and accounts, company meetings and visits and governance engagements.