Impact of new regulations, MiFID II, on asset management: Eaton Vance
On January 3, 2018, extensive new regulations impacting the capital markets will go into effect, impacting European and Global asset managers. These regulations, known as MiFID II, cover a broad range of topics, but the one getting the most attention is the unbundling of trading commissions.
Eddie Perkin, chief equity investment officer at Eaton Vance, presents the likely consequences of this new regulation on equity asset managers.
MiFID II will put an end to a bizarre business model:
The current revenue model for equity trading is truly bizarre. Brokerage firms provide various research services to analysts and portfolio managers at asset management firms. These services include: written research notes (on companies, industries, policy and macro), earnings models, meetings with sell-side analysts, industry conferences, arrangement of meetings with corporate management teams, and more. These services are aggressively pushed at the analysts and PMs of large firms like Eaton Vance.
After some period of time, often 6 months, the buy-side analyst is asked to “vote” for the brokerage firms that provided the most/best service. These votes are aggregated and influence where trades are sent in the ensuing period, subject to best execution requirements. Since the trade’s commission expense is bundled, the brokerage firm has to guess how much of the payment is for research previously provided, and how much is for the cost of executing the trade.
To illustrate the absurdity of the process described above, consider an analogy. Imagine a family goes into an all-you-can-eat buffet restaurant. Each member of the family gorges on various items. Six months later, each individual is asked to vote on which restaurants he/she liked best in the preceding two quarters. Based on that, a check is sent to the restaurant along with a few comments about which items of food had tasted particularly good.
This crazy system dates to the early 1970s when fixed-rate commissions prevented brokers from competing on price. Instead, as costs fell, brokerage firms competed by offering more and more services to clients, including research, gifts, and entertainment. On May 1, 1975 (May Day), the fixed-rate commission regime ended, but the in-place business model has survived to this day.
MiFID II requires asset management firms to effectively unbundle commissions, tracking and paying for all research that is consumed. The days of gorging at the buffet are coming to an end. The year 2018 will be a voyage of price discovery where the world finds out what brokerage research is really worth.
MiFID II will make asset management a scale business
Although not required by MiFID II, a number of asset management firms have elected to take the cost of external research in Europe onto their own P&Ls. For many asset management firms, these costs typically run into the multiple millions of dollars per year. One does not have to be a cynic to believe that some of these firms may reduce their research consumption if they are paying for it directly themselves. The problem for small asset managers is that their investment processes are often very reliant on external support from the Street.
For EVM Equity, we have roughly 50 portfolio managers, analysts, and associates collectively covering thousands of developed market stocks around the world. We do our own proprietary research and have direct relationships with our portfolio holdings. We welcome a world where our smaller, boutique competitors struggle to get access to company management teams and voluntarily elect to cut themselves off from various critical resources.
MiFID II will be a boon for active management:
As both the consumption level of -- and willingness to pay for -- external research collapses in the coming months, brokerage research in Europe will likely be decimated. Estimates for the year-over-year change in equity research commissions for 2018 range from -25% to -50% though we have been told off the record by a contact at one of the bulge bracket firms that they expect a collapse of -70%. This will force layoffs. It will force consolidation among brokers. This will lead to reduced levels and quality of equity coverage, particularly for small and mid-sized European stocks.
Small-cap stocks are already underfollowed and inefficiently priced. Post MiFID II, investing in European small caps for a well-resourced active manager will be like playing poker against someone who never bothers to look at his own cards. I was recently speaking with a European equity analyst with three decades of experience. He told me, “The European equity market in the 1990s was so inefficient. It was easy to generate 300-500 basis points of alpha each year. MiFID II is going to take us back to those days.”
Why would anyone buy an index fund!?!
Conclusion:
I have been studying MiFID II for more than 18 months. This has involved dozens of migraine-inducing meetings with lawyers and sell-side executives. I have moved through each of the five stages of grief. I have now reached a sixth stage… fascination. I am eager to observe the market-disrupting consequences of this new suite of regulations, and to pounce on the opportunities it inevitably brings our way. Between the impact of MiFID II and a once-in-a-generation overhaul of our corporate tax system, it is a safe bet that the low volatility regime is coming to an end.
Note : these views are those of the CEIO, Eddie Perkin, only and may not reflect the views of other equity portfolio managers within the Eaton Vance Management Equity Group and/or positioning across our equity portfolios.