Global Third-Party Research: An Industry In Crisis?
By Jeremy Monk
Research coverage by analysts at investment banks and other third-party research providers has plateaued in quantity in recent years. That’s according to a study we conducted at AKRO investiční společnost, a Prague-based investment firm. The results confirm what many have suspected: The global third-party research industry has gone “ex growth.”
Since the number of analysts at major investment banks has dropped by as much as 20% since 2010, according to figures from Coalition Development Ltd., this finding may indicate improved productivity overall though it also raises questions about potentially diminished research quality.
While there were some variations across the three regions examined in our study, the results indicate that recent Markets in Financial Instruments Directive II (MiFID II)regulations in the EU requiring that banks “unbundle” investment research charges from their trading commissions have not yet caused a drop-off in research output. Indeed, throughout Europe there has even been a paradoxical upward blip in coverage since MiFID II came into effect on 3 January 2018. Though that blip may prove short-lived, it suggests there is increased pressure on research analysts to improve productivity and justify their cost. In this respect, against the current backdrop of somewhat alarmist headlines and dire predictions, the long-term impact of MiFID II on research output is still unclear.
What is research coverage and why is it important?
Research coverage describes how many financial forecasts are published by analysts for each company included on an index. Adequate research is critical for the capital markets to function properly: Sparse or low-quality analyst coverage can lead to lower valuations and lower trading volumes, and increase the potential for the mispricing of securities and market manipulation.
The Financial Conduct Authority (FCA) in the United Kingdom and the EU’s European Securities Market Association (ESMA) will conduct studies on how MiFID II has affected research coverage. Of course, while the quality of research output is difficult to assess, the quantity can be objectively measured. So what will ESMA and the FCA likely find?
AKRO’s study collected all published analyst forecasts covering earnings per share (EPS), net income, and sales for the constituents of three leading equity indexes: the Japanese Nikkei 225, the US S&P 500, and the STOXX Europe 600. Only Bloomberg’s Standard Consensus forecasts were used, so no out-of-date data was included.
In aggregate, analyst coverage across all three indexes increased steadily until 2009–2010. For example, at year-end 2007, there were approximately 17,400 analyst EPS forecasts for the companies of all three indexes. That averages out to 13 analysts or teams of analysts covering each company. By 2010, that figure had risen to around 21,700 forecasts, or just over 16 forecasts per company. Since 2010, however, forecast quantity has remained static, with 21,600 total as of 29 June 2018.
These findings hold true whatever the forecast item — EPS, sales, net income — and whatever the market.
Methodological Note: The analysis utilized Bloomberg data for the standard consensus of sales, net income, and EPS. Except for 2018 data, which is as of 29 June, all data is year-end for the index constituents at that date. The total number of estimates for each data item (EPS, sales net income) varies because Bloomberg excludes forecasts that are not done on a basis consistent with those of other forecasters. Bloomberg’s data on the total number of analyst recommendations, which some other commentators have referred to, was excluded from the analysis because Bloomberg has confirmed to the author that, unlike its consensus forecast data, the data on the total number of recommendations can include out-of-date recommendations. The indexes chosen represent, with minor exceptions, a finite number of stocks: 225 in Japan, 500 in the United States, and 600 in Europe. Bloomberg data includes the output of most major third-party research providers, such as investment banks and independent research boutiques.
This data does reveal some interesting regional differences. While certain trends like the growth of passive investing are global in nature, how they influence research coverage has varied among markets.
In Europe, research coverage peaked in 2009 and has since declined, a result of the ongoing restructuring of the European banking sector, among other factors. In 2009, there were 11,371 separate EPS forecasts for index members, or 19 forecasts per company. By December 2017, that had fallen by 21% to 8,955 forecasts, or 14.9 per company.
More recently, the data demonstrates MiFID II’s short-term impact, with this year’s upward blip in research output. The number of published EPS estimates for STOXX Europe 600 constituents has jumped just over 10% since year-end 2017. For the moment at least, MiFID II has increased research output as research departments seek to boost productivity amid nervousness among analysts about potential cuts in headcount.
This MiFID II blip represents the first significant increase in European stock coverage since 2009.
The US data demonstrates the effects of the financial crisis and the subsequent recovery. While the European banking industry has languished over the last decade, its US counterpart has enjoyed a steady upswing. At first glance, the plateauing of research coverage since 2011–2012 is puzzling. The most credible explanation for the stagnation amid bullish equity markets is the increasing prominence and popularity of passive funds.
“[S]tarting in 2011, flows into passive funds (which includes ETFs and index funds) have outpaced flows into active funds every calendar year, despite the fact that active funds outnumber passive funds by eight to one,” Patricia Oey observed for Morningstar. “While passive funds have drawn more assets than active funds during these six years, the difference in flows for the two groups has also widened significantly.”
The implication is clear: Research departments at third-party research providers, particularly those within investment banks, have borne the brunt of the surge into passive investing. These pressures have, in turn, been reflected in the level of analyst coverage of listed companies. This makes sense: Passive investing, by its very nature, does not require analyst research. Therefore, it is probably no coincidence that one in five equity research analyst positions at big investment banks have disappeared since 2010.
Furthermore, the growing prominence of low-cost passive funds combined with investors’ search for value for their money has had a general knock-on effect on fee levels at active funds and indirectly on how much those funds can pay for third-party research from outside providers.
“Investors paid lower fund expenses in 2017 than ever before,” Oey observed this year for Morningstar, with the average fee charged by active US equity funds falling 5%.
In Japan, the research coverage situation falls somewhere in between that of the United States and Europe. Overall research coverage looks to have peaked in 2010 with evidence of a certain degree of attrition in recent years.
Results from the S&P Small Cap 600 indicate that there is much less small-cap coverage. In 2012, there were 5.1 analyst forecasts per small-cap index constituent on average, with 117 firms falling into the “neglected” range, with fewer than three analysts covering them. As of December 2017, the average had fallen to 4.7 per company, with 125, or 21%, in neglected range. This suggests small-cap coverage is experiencing a gradual attrition.
The STOXX Europe Small 200 is made up of the smallest STOXX Europe 600 companies and has also seen an upward blip in coverage since the introduction of MiFID II. In 2009, there were 2,664 separate EPS forecasts for members of the index, or 13.3 forecasts per company. By December 2017, that had fallen almost 14% to 2,299 forecasts, or 11.5 per company. Coverage has jumped 7% since the start of the year.
Despite the strong recovery in equity markets since the financial crisis, global research coverage from third-party providers has stagnated. Research coverage in European markets has experienced a particularly steep decline.
This is an inauspicious backdrop for the implementation of MiFID II which has put yet more pressure on investment banks to cut research overheads.
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