Change is on the way… BIG change! On January 3rd, 2018, MiFID II takes effect. MiFID was designed to make the global markets more transparent, but one seemingly innocent new rule could blow the markets apart. Starting January 3rd, Equity Research must be paid for, instead of being bundled in “trading fees”. Trading fees and research fees must then be separately and explicitly billed. Let’s dive right in and see just how much today’s “free” research is worth!
Equities valued at trillions of dollars are traded around the world. But which stocks should you buy and sell, and when? The answers are found through research! Equity research is a multi-billion industry. Investment banks have huge Equity Research departments. Smaller trading firms have specialized research groups. A few firms even independently sell research. And then, of course, there are global data providers (Bloomberg, Thomson-Reuters, S&P, Moody’s etc.) that sell Research departments all of their data from stock exchanges.
Yet, research is given away to Institutional Investors for free. In exchange, Institutional Investors buy stocks from those brokers that provide research. But when research isn’t for free? PAYING FOR RESEARCH changes everything! Not only will fund managers (and their financial managers), question what research costs and how much is needed, they will question how they are charged. There is, unfortunately, no roadmap.
Every broker will have a different plan on how to charge. Some will bill each transaction with execution and research fees, others will charge a flat monthly rate. A few will further separate billing into written research vs. consulting time with analysts. Better known research departments are expected to charge $5,000 to $10,000 per hour to discuss stock insights with analysts.
MiFID is not a US regulation. It was created by European regulators and only applies to equity sales in Europe. MiFID was created to level the fragmented EU playing field. Since research is given away, but Institutional Investors only buy from brokers with “free” research… this arrangement has the appearance of an “inducement” to do business. When “gifts” worth millions of dollars are given away, it’s not a level field. Alternatively, when research is no longer free, will clients still need the thousands of reports that are created every week?
January 3rd could be a quickly forgotten blip, or it might be the day that all hell breaks loose! Let’s do our own countdown to MiFID II and see what we learn! Starting with…
10… Cost Some research groups only research a few stocks, others offer global coverage. That translates into different billing rates. Some will be visibly higher, some considerably lower, and some will be more difficult to compare. On day one, expect client feedback to contain a lot of negative comments about overcharging, and demands for remediation. The rest of 2018 could be a firefight over rates. Billing will be renegotiated, and research products will be re-aligned to match client demand. Expect changes in the number of research providers and their staff by mid-year.
9… Competition Institutional Investors manage trading disruption risks by working with multiple brokers. But after January 3rd, multiple brokers cause duplicate research fees. If you use 5 brokers, are they each providing unique research or are two or more providing the same information? Are you willing to pay for duplicate research? Does every broker give you value for each research Euro?” Or Dollar? Speaking of which…
8… US vs. EU Clients MiFID is a European regulation, but global clients will quickly ask, “If European clients know their costs, why can’t I?” Wall Street is very aware of MiFID. Clients will demand voluntary adoption of MiFID billing rules. Don’t want to provide it? Are you willing to bet that Washington will provide a better standard? If your firm follows MiFID today, you might have a single U.S. and European rate. But if you wait, you might be required to follow separate U.S. and European billing rules. And how will you bill for research in China (and “other” areas)?
7… US vs. EU Regulators Most global firms consolidated their local research offices into a central operation years ago. But MiFID complicates how global operations work. It’s more than just how they allocate billing. EU research must be produced by EU registered analysts, just as US research publications require FINRA registered analysts. Managing analyst registration and duplications in expertise is another task that MiFID adds to global research. As MiFID regulations continue to be written, more conflicts will arise between US and EU offices, raising costs.
6… Duplication Billions are spent on research, but what is it really worth? A study from Reuters found that the top 15 Investment Banks produce 40,000 research reports every week, but clients read less than 1% of these documents. Even with this huge number of research reports, not every stock is fully covered. Research is overly focused on the “top stocks”. Thirty analysts cover HSBC, with 50 covering Apple. The top 3 or 4 analysts might have original insights about a stock. But what about the least insightful analysts? Fund managers don’t read 99% of reports. How many will they pay for?
5… Bias The Financial Times of London stated, “The “Buy/Sell/Hold” headline is both heavily regulated and more or less worthless.” If research reports are sales documents, we expect them to over-hype equities, just as they do today. For example, McKinsey, the world’s largest consulting firm, reported that earning growth estimates are 100% overstated. When research is no longer free, will accuracy matter? But accurate research would produce fewer buy recommendations, and lower trading volumes?
4… Indexing Index Funds and passive investing are now 30% of total equity fund assets and growing. Index funds, outperformed 80% of actively managed funds, without traditional research. As more money flows into Indexed Funds, fewer traditional trades must absorb research costs. Either fees will rise or costs must fall.
3… Whale Hunt The more a stock is traded, the more coverage it receives. Top firms are over-covered and small cap firms (with low trading volumes) lack coverage. Small cap firms rarely produce the revenue needed to pay for research coverage. However, research departments that are able to dramatically lower the cost of research can transform small cap from a financial burden to a profitable new market.
2…D.I.Y. According to the Financial Times, Vanguard expects to pay $5 million in research fees in 2018. Another firm that is a mere 10% of Vanguard’s size, but with more complex research needs, expects to pay $10 million. That’s enough to start a research department. It is inevitable that some Institutional Investors will simply write their own research. How many will “defect” from the current system?
1… Market Data Services We’ve only discussed brokers and Institutional Investors. If just a portion of these changes take place… the breakup of global research, fewer researchers, changing research products… market data providers must quickly pivot, and develop a new research model with fewer subscribers and smaller budgets.
Launch… It’s anyone’s guess what research will look like in 2019. But in 2018, research quality must rise, costs must fall, and operations must be flexible enough to deal with ongoing changes. Artificial Intelligence is the key technology to offset MiFID changes. AI can write the primary research, allowing high-end analysts to identify new trends and provide original insight. Research departments that do not aggressively adopt AI will lack the resources to produce the quality research clients demand, or they will simply price themselves out of the market.
Tough times are ahead for Equity Research. MiFID is still open to interpretation, but it has already triggered seismic changes. Research departments will soon struggle to reinvent themselves, with fewer analysts, reduced budgets, and a mandate to create unique research. Not every research department will survive. But a few of today’s research departments will aggressively adapt Artificial Intelligence and other new technologies that transform the cost of research and define the next stage in Equity Research.