MiFID II: What It Is and What It Means for Your Investments
MiFID II (which stands for the Markets in Financial Instruments Directive) is a set of regulatory reforms established by the European Union. Its aim is to increase transparency and efficiency as a way of promoting increased investor confidence in capital markets. This wide-ranging reform covers trading, client service, and reporting requirements for investment managers based in the European Union. The Directive encompasses equity, fixed income, commodity, and currency trading markets, as well as retail focused elements of derivative trading. The legislation was drafted in 2014 (building on the MiFID reforms that were originally enacted in 2007), and will finally take effect January 2018.
What Are the Implications?
While many of the elements of the reform are rather mundane, one particularly noteworthy piece relates to trading – specifically the bundling of research costs paid through ‘soft dollars’ (commissions for money managers that are generated by financial transactions within the accounts they manage).
Why Does This Matter to Investors?
Although the legislation is focused on investment managers operating in the European Union, there is a broad expectation in the market that these reforms will lead other regulators to introduce similar measures and that will eventually be a convergence of regulations. As a result, many global investment managers (with operations across EU and non-EU territories) are considering whether they should apply the same standards to all clients around the world, because adopting a dual standard within a firm will be logistically complex and potentially more expensive.
In addition, some U.S. based investment managers are working towards voluntarily complying with the intent of the legislation. Even those that are not looking to comply with the legislation now are considering their options going forward.
Regardless of whether your plan’s investment managers are actively looking to comply with the reforms, the changing landscape of research payments is likely to dramatically impact the sell-side investment research industry. Sell-side research can be defined as industry and/or company-specific investment research and recommendations provided by brokerage firms, which are used by many investment managers to supplement the research that they conduct in-house. Currently much of this research is paid through the soft dollars that we refer to above, meaning, the ultimate cost has been borne by the client through higher trading costs. Under the new regime, these costs will be paid in hard dollars (i.e. actual money). It will be up to the investment manager to choose how this is funded, either by treating it as a business expense on the firm’s own P&L statement, or by attempting to pass it through to clients.
Segal Marco believes that the change in fee structure for sell-side research may lead to some unintended consequences in the market. The sell-side research industry is likely to reduce in size. Management consultant McKinsey estimates that the industry could shrink by as much as 30% and with an oversupply of employment, there will be lower compensation, resulting in the best analysts changing to a different industry and a reduction in the overall quality of research.
The remaining sell-side analysts will likely focus on researching areas of the market which have the most interest, potentially making value, small cap, and non-U.S. markets more inefficient in terms of price discovery, increasing the number of opportunities for active managers. In turn, this may lead to an increase in the cost of borrowing for smaller businesses, as more companies have to turn to private debt to raise capital.
How Should Trustees Respond?
Segal Marco believes that the cost of research should be borne by the investment manager, and view any additional transparency relating to costs as a positive development.
Over the past several months, many investment managers impacted by MiFID II have publicly disclosed whether they will be adopting the approach of expensing sell-side research or passing on costs to clients. The general trend has been for investment managers to absorb the expense, generating some pressure for this to become the industry norm.
In the meantime, any clients that are in the process of selecting investment managers should ensure they have clarity on the way different investment managers are structuring their fees in order to make an effective comparison. Just one of several factors that should influence a decision on selecting an investment manager.
How Will This Impact Our Existing Investments?
When Segal Marco Advisors’ Alpha Research Team assesses the pool of rated ‘Recommended’ investment managers, almost all of them conduct their own proprietary research, relying only on sell-side research for broad industry information or to assess market consensus. This means the amount of sell-side research actually utilized by this select pool of investment managers is much less than what they have been receiving.
With the introduction of explicit fees, we expect significant reduction in the overall consumption of sell-side research, and an increase in the bargaining power of managers. Some investment managers say they have been able to negotiate a reduction in sell-side research costs of more than 75% in the past 6 months.
We have been discussing the implications of MiFID II legislation with all of our Recommended managers that are operating within the European Union (including those based in the United Kingdom despite the impending Brexit). The final draft of the reforms was recently issued in the summer of 2017, with many regulators (such as the SEC) slow to dictate how they would respond. As a result, some smaller investment managers are just finalizing all of the necessary requirements for implementation.
We are confident that all of our Recommended managers will be ready for MiFID II in January 2018, and we will wait to see how things will impact our industry over both the short and long-term.