Interview: Sell-side research should move to a select-from-menu offering

In our May Nordea On Your Mind ("Liquidity drought"), I interviewed Nordea Asset Management's John Hernander, CIO of Nordic, Finnish & Swedish Equities and Portfolio Manager of Swedish Equities, and Mats Andersson, Portfolio Manager for Nordea's Nordic small-cap equity fund, on how MiFID II will impact business models for asset management and investment research as well as how it could affect liquidity, equity values and the ability to use equity-based executive incentive programmes, particularly at small- and mid-cap listed companies.

The MiFID II regulation changes the playing field for both the buy-side and the sell-side in the securities industry – has it driven any major changes to your business in Nordea Asset Management?

John: I think MiFID II has to some extent benefited us at Nordea Asset Management, as we had already sharpened our broker evaluation model before the new regulation was implemented. We made a major overhaul of our investment process several years ago, establishing our long-term investment horizon of three to seven years, and strengthening our in-house fundamental research capabilities. We were keen for all our broker suppliers to understand our needs under this model and to build transparent monitoring internally of how we use the services of our brokers.

We became very systematic in logging all interaction with our brokers, and rating it, in order to give better feedback to brokers and to improve our own visibility of what we actually use and how it creates value for us. With this already in place, we do not need to start from scratch. But we may need to do a bit of further calibration to comply with the MiFID II requirements for reporting our costs for research from external parties, and – particularly – for reporting the impact that the research we have received has had on our investment performance.

So, I think the way we already decided to be structured, systematic and transparent in our investment process, and in how we use our brokers, fits quite well into the MiFID II regulatory framework. And this is both for managing broker relationships and for arguing and describing our own value proposition to our investor customers.

Mats: I think it is also worth highlighting that we took a decision to take all costs for research from external parties in our own P&L, not letting our investors pay for it through our fund management fees, before MiFID II was implemented. In that sense we were also well-prepared when MiFID II made this mandatory, both from a practical and administrative point of view, and from a fund manager mindset perspective. We have not seen broker research as an endless, free resource. We are used to thinking about what research we think we need and why we need it.

One change I have noted since MiFID II is that brokers are now trying to get paid a higher commission for trading blocks. Under MiFID II, trade execution is paid for separately and at a lower commission rate than the historical rates that used to include sales service and research. For the small-cap stocks my fund invests in, volume transactions are by and large done through blocks changing hands. I now find that brokers often ask for a higher than normal commission rate after we have bought or sold a block, arguing that the block trade was a special, non-standard transaction. This is new, and perhaps reflects some pressure to make up for revenue shortfalls under MiFID II – especially for brokers that do not have meaningful revenue streams from research under the new regulatory regime.

What is your view on equity-based executive incentive programmes in listed companies, and do you see any risk that lower liquidity – particularly for shares in small- and mid-cap companies – could make them more difficult to use in the wake of MiFID II ?

John: We are very keen on liquidity in the shares of listed companies in which we are shareholders to be good enough to allow the use of equity-based executive incentive programmes. We put a lot of effort into checking out what incentive programmes companies use, and we engage in a dialogue with management and the board of directors to ensure these programmes are based on achieving objectives that require effort to achieve and are aligned with the interests of shareholder. Incentive programmes are common but they vary greatly in character. We believe programmes with the right structure can be a powerful tool for boosting corporate performance, and it would be a missed opportunity if the share liquidity is too weak for management to be able to sell shares to cover tax liabilities upon divesting incentive programme shares. If liquidity deteriorates, this is of course a concern, and something we need to look into when discussing with boards how to design incentive programmes.

A key feature of MiFID II is unbundling of research and execution services for securities from brokers and banks. At NAM you already have a strong in-house research capability. What is your view of the future role of sell-side research? Is it needed at all? What kind of research do you value?

John: I think sell-side research will have to move to a select-from-menu offering. I realise there is a powerful legacy structure in the industry, but MiFID II is challenging the relevance of this legacy. Change can be difficult and painful, but I think sell-side firms need to be flexible to offer different customers different things, to be able to adapt the output from the research organisations they have built to be relevant and useful for many clients with different needs.

The old sell-side investment research business model was a one-for-all offering, with a negotiated commission rate giving the asset manager access to all the broker's research, regardless of which research was actually valued or used. Now that asset managers have to pay for all research themselves, report the costs and show the regulator what their investors received for those expenditures, they are bound to be pickier about what research they actually buy. I think brokers would do well to be smart and selective in how they use their research distribution capabilities, to be able to efficiently sell each asset manager those items on the research menu that they are prepared to pay for.

Mats: We invest with a long-term view and have limited interest in quarterly previews and reviews. This holds especially true for small- and mid-cap stocks, where limited liquidity would not allow trading around quarterly results anyway. We are interested in critical pieces of the puzzle – big or small – that make the analyst actually change his or her view.

John: Yes, exactly. An analyst having an instant view on a set of quarterly results is one thing, where we most appreciate a prompt and convenient way of getting the conclusion. I think sending out a deviation table is more efficient than calling around during a busy reporting season. And we encourage analysts to send this out to our whole team. Those team members who happen to be interested can come back and ask for more colour as needed.

The analyst's thoughts and fundamental conclusions after going through a report in detail, and updating forecasts and valuation, is another thing. We typically value this more than the immediate take on a quarterly report. And it is not that time critical. It can be every bit as valuable for us if it comes one or a few days after the report, when the analyst has had time to reflect on all aspects of the investment case. And again, it can be sent to the team in any convenient way. There is no need to call around, particularly with low-impact stock calls, for the sake of being able to log phone calls to show that you have been active in servicing clients. If the analyst's thoughts and conclusions are relevant and important for us, we will surely reach out.

On a general level, I see a risk that MiFID II could stifle rather than stimulate competition in sell-side research. There is a scale aspect to sell-side research as well, regarding compliance, reporting, IT and infrastructure. And asset managers will not typically be prepared to establish bilateral agreements with a vast number of broker suppliers, as there is now a regulatory requirement to pay every counterparty for their research – and reporting on the cost and the performance impact of the research has to be done for each counterparty. This means that asset managers may decline service from weaker sell-side players, even if they have one or a few "star" analysts whose research they would actually like to get. This is a potential waste of talent.

There is a drive for scale in the asset management industry, with bigger funds growing bigger still, to absorb costs for compliance, etc. Could it be a challenge for big funds to try to increase their active share, as they need to take bigger positions in fewer companies?

John: There are strong economies of scale in fund management, up to a point. If funds grow too big, there are diseconomies of scale from increased complexity, such as a bigger investment product flora, etc. I think an equity fund with EUR 100m in assets under management might be difficult to run profitably today, while a EUR 1bn fund should not have any critical scale problem.

Mats: And don't forget that complexity rises sharply if you operate in several countries. Nordea has small- and mid-cap equity funds registered in three different jurisdictions: Finland, Sweden and Luxembourg. There have been occasions when fund matters have not had identical compliance status in different countries, which can cause problems.

Are there liquidity constraints for investments by your big equity funds? For your small-cap funds? Will MiFID II make them worse?

John: For our large-cap funds, I would say we have not seen any major negative impact on liquidity from MiFID II so far.

Mats: We measure and evaluate liquidity risk for the whole fund and allow exemptions for small-cap stocks, which are typically traded in blocks. The day-to-day turnover data for these small-cap stocks is not that meaningful as a liquidity measure, as major positions in them have to be traded as blocks, brokered between buyer and seller. We have had examples of our measuring systems warning that one of my small cap positions would take six months to sell in the market, where it was in fact sold as a block in one transaction in a day. Therefore, we look at portfolio risk on an aggregated basis, which gives room for our small- and mid-cap funds to show higher liquidity risk than our large-cap funds.

We want our trades to be visible on regular exchanges so others can see when we invest in companies and believe in them as an investment. MiFID II could bring a risk that more share trading would move off-exchange, despite the regulation actually aiming to achieve the opposite. This would reduce transparency in the market.

I can't say that I have so far noted any big change in liquidity since MiFID II was implemented, but I do have a concern that we need to ensure that we are first call for brokers when blocks of small-cap shares are to be moved. This is key for our value proposition to our fund investors. For these smaller listed companies, where daily trading liquidity is too low to represent a fair and true share price for any sizeable volume, we need to be one of the key active investors in the stock, almost guaranteed to be shown any block of shares for sale or in demand. And this of course requires that we are a valued and attractive counterparty, as per my earlier observations about some brokers now wanting to be paid extra for trading blocks. I would say so far so good in how this has worked out this year, but we will need to monitor closely how these market dynamics will evolve.

If liquidity suffers after MiFID II implementation, how will it affect your business? Lower expected returns when you move share prices when investing? Smaller investable universe? Other effects?

John: Again, we look at portfolio liquidity risk on an aggregated level, so if we felt strongly about owning illiquid stocks, we would have to concentrate other parts of the portfolio into more liquid names.

Mats: We have seen very clearly that when a stock has low liquidity, its valuation suffers a higher risk premium. This means a higher capital cost and hence a lower equity value, all else equal. As an institution, we have a long-term investment horizon, and can be opportunistic and buy into companies with weak liquidity more cheaply with the expectation that it would normalise at a later stage, when the company has grown bigger, or widened its ownership base with a greater free float. But listed companies certainly suffer from lower equity valuations when liquidity weakens.

What is your view on commissioned research, coverage paid for by the listed company? Is it a useful tool to support interest, liquidity or valuation for smaller, under-covered companies? Does it have any drawbacks?

Mats: We have found this service only helpful and valuable so far. We are fully aware that the research is paid for by the company, and consider any potential conflicts of interest or agendas on the part of the authors as we do for all the other research we read. We don't view commissioned research any differently than traditional sell-side research, including IPO research, in this respect.

It is not just the written research that can be helpful, but also road shows and events. I recently met with several Finnish small-cap companies, which I had otherwise not been able to know on my own initiative. They were taken to Stockholm to meet investors by a local broker they had commissioned for research coverage.