I want to start this piece with a quote:
“Judge public policies by their results, not their intentions.” – Milton Friedman
There has been a lot of change in finance over the last ten years – on both the product/business side, but also on the policy side. Some of these changes were welcomed, and some were not.
Over the last few years, there has been a growing discussion and rumination about how some of the new policies and business models would react to a crisis – there was talk of the “death of robo advisors” (as people would demand to talk with a human), there was the “death of crypto” (as everyone would fly to ‘safe’ assets), and there was the “death of passive investing” (as market volatility would reward active investors). Some of those might be true, some look to be true, and some clearly were wrong. Wall Street missed one potential though – something that was so taken for granted, that it was never on the discussion list:
The death of MiFID II
MiFID II (following MiFID I) had good intentions: market reforms to drive more transparency to the industry. One of the big pillars of MiFID II was the unbundling of payments for research (and research services) and payments for execution. The idea was that funds should be able to clearly articulate what they were paying for in each of the two buckets, and take on some of the costs themselves (vs. passing them on to investors). That was the intention, but as Milton Friedman pointed out, we must judge policies not by their intentions, but by their results.
The results were clear: for fund managers that fell under the purview of MiFID II, as a result of the policy, they had access to less research, covering fewer companies and topics. Ultimately, they had less access to information.
It was a simple lesson in undergraduate economics: research demand decreased (as firms had to begin paying out of pocket, eating into already thin margins), and given the research supply originally stayed quite flat (no firms would willingly exit the business overnight), the price dropped. As prices dropped, firms struggled to maintain healthy economics, and some left or were forced out of the business, causing supply to drop. Unfortunately, prices were capped, so the market didn’t rebalance, and prices didn’t increase – they just stayed flat. Rinse and repeat over the last few years, and we now find ourselves in a very different landscape.
Enter COVID, stage left.
With the pandemic restructuring and impacting the entire world, and every single government, industry, company, and individual within it, there was a race to understand what the implications would be – and this was a race whose core competitive advantage would come from access to information. Specifically, the speed and velocity at which that information could be accessed, consumed, and acted upon.
Each investor needed to understand which companies would be impacted, how they would be impacted, and where the opportunities would be. In times like these, you don’t have time to do a deep dive into each individual company, and learn about them from the bottom up – you need to lean on experts, and those experts exist at research firms. Unfortunately, many European investors found that they no longer had access to the information they needed.
All of a sudden, one of the most unintended intentions would lead to one of the most painful results: investors in markets dominated by MiFID II would be at a massive information disadvantage. Bloomberg is already reporting on the fallout, as US firms dominate their European peers, but my guess is that this is just the beginning.
While I’m no regulator (and I don’t think I ever could be), I believe the misstep in MiFID II, while well intended, was the wrong optimization. Instead of optimizing for the costs investors paid out of their assets under management (such as for research, and execution) as a way to drive performance, they should have been optimizing for the returns that investors ultimately received. Yes, they are very closely tied together, but no, they are not the same. Optimizing costs assumed that performance would stay flat given a reduction in costs, thus driving a net benefit to investors – and it looks like that assumption was wrong. When you have less money to spend on information, you also, incidentally, get less access to information.
In the current regulatory environment, the onus is on investment managers to rationalize how much a piece of research should cost, not how much value it creates. As any investor knows, sometimes the biggest ideas can come from the smallest places – a quick note, a trade idea, a call. It can lead to portfolio rebalancing, position changes, or a myriad of other decisions – but under MiFID II, you can’t really reward someone for that ‘small’ value – no matter what the ultimate impact was. By trying to standardize the cost of every piece of information, we’re losing the forest from the trees – that’s simply not how the human brain works. The bigger the mountain of information you’re mining, the more likely you are to find a gold nugget.
In the current crisis, we find ourselves in a world where one half of the market is starved for information, and one half isn’t. We find ourselves in a market where many research firms have reduced coverage, or ultimately exited the market. We find ourselves with fewer companies being covered, and the ones that still remain covered having less coverage.
While the intentions were amicable, we must now look at the results – and to me, they seem quite clear. The Grand Experiment of MiFID II has met its first crisis, and the crisis has won.