Updated with correction
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.
Fewer doing research
Jean Roche, U.K. and euro small-cap manager at Schroders PLC in London, concurred. "The quantity of research is declining," she said. "There are fewer companies doing the research, which means firms are being more selective in the corporations they are analyzing."
Anthony "Tony" Dalwood, CEO of U.K. small-cap specialist manager Gresham House PLC, said: "MiFID is creating opportunities for investors to generate alpha" in smaller company investment. If there is no research, fund managers will tend to overlook companies, he said.
Mr. Dalwood added that Gresham House is partnering with Aberdeen Standard Investments to launch a new small and midcap fund. Gresham House, which has £2.3 billion in assets under management, formed a joint venture in March with Aberdeen Standard, and Aberdeen took a 5% stake in the firm. Aberdeen, with £505.1 billion in assets, manages $15 billion via its small-cap fund family.
Peter McKellar, global head of private markets at Aberdeen Standard, said in a March news release: "The structural changes, liquidity issues and declining research coverage among smaller companies provides a long-term opportunity to generate significant investment returns for our clients."
Gresham House's small-cap fund, Strategic Public Equity, returned 8.9% in 2018, representing 22.7 percentage points and 18.4 percentage points outperformance vs. its Small Cap Total Return and All Share Total Return indexes, respectively.
The MSCI U.K. Small Cap index returned 22.75% year to date through April 30. On an annualized basis, the index delivered a 7.47% return over five years and 14.97% in 10-year period. In continental Europe, small-cap equity also did not disappoint, with the MSCI Europe Small Cap index delivering a 17.3% year-to-date return through April 30. The annualized five-year return was 4.54%, while over the 10-year period, European small-cap equity delivered a 13% return.
Funds are being launched because of the research gap created by MiFID II, sources said. In 2018, London-based boutique manager Odyssean Capital LLP launched a joint venture with small-cap equity manager Harwood Capital LLP.
In a February 2018 news release, Stuart Widdowson, managing partner at Odyssean Capital, said: "We believe the introduction of MiFID II legislation will lead to many more opportunities to find mispriced U.K. smaller-quoted companies over the next few years, so timing could not be better to launch our investment strategy."
But not all are seeing opportunity.
Kasper Elmgreen, head of equity investment platform at Amundi in Dublin, was less optimistic about the magnitude of MiFID II's impact of on the small- and midcap research. "Overall, the change has been less dramatic," he said.
"Before MiFID II, people said MiFID II will have a significant impact on the research produced. It has not panned out as much as it was advertised," he said. "There is not enough evidence that the regulation has created (such an) opportunity" in small- and midcap stocks.
What has changed, Mr. Elmgreen said, was that "research has moved from an 'all-you-can-eat research menu to a la carte. "There is a cost assigned to each type of research," he said. The firm also is seeing that the analysts who cover small companies tend to be more junior, a reflection of the need to keep research costs down.
According to Andrew Neville, portfolio manager at Allianz Global Investors in London, the "impact of MiFID II seems to be theoretical."
He said clients are more focused on the effect of MiFID II and "how we are coping with the research falling. We think we can cope well."
Mr. Neville also is seeing a difference in companies covered. "The research of (the) top end of small companies is high, while (the) bottom end is lower," he said, adding managers are focusing on more liquid companies.
Sources said that since brokers are being more selective about the companies they cover, companies are now paying brokers to raise their profile by including them in research reports.
Mr. Neville said the companies are becoming desperate to find "access to people" who can get the attention of money managers.
"The business of 'paid research' has expanded as a result of MiFID II. Companies pay to be covered by investment banks," Amundi's Mr. Elmgreen said.
Asset owner interest
And as research wanes, asset owners are showing more interest in the asset class. According to data provider eVestment LLC, pan-European small-cap equity strategies saw $1.8 trillion in net inflows in 2018 alone, compared with $3.2 trillion net inflows in the last three years and $3.6 trillion net inflows in the last 10 years.
Justin Preston, senior director, head of equity, public markets research at consultant bfinance in London, said in a telephone interview: "We see a little bit of a pickup in small- and midcap equity searches, but we don't think it has to do with MiFID II."
"As investors moved to global equity, they moved further up the cap spectrum," in effect becoming underallocated to small-cap equity, he said. "Now clients are saying, we don't have small cap — can you help us find it?"
Salwa Boussoukaya-Nasr, CIO of €32.7 billion ($36.4 billion) pension fund Fonds de Reserve pour les Retraites, Paris, which has been searching for active small-cap equity managers since last year for the fund's €1.1 billion allocation, said for large cap equity it is better to be passive because of the lower cost of managing the assets.
But "for small caps, a number of managers have good track records that have outperformed the market," she said.n