It is time for us to squint into the crystal ball for 2014…
By rights, 2013 should have been a boom year for equity commissions. The S&P 500 increased 32% for the year, and trading volumes should have surged also, yet we estimate that trading volumes for US equities were down 5.5% in 2013. What will it take for trading volumes to increase?
Although 2013 was frustrating for what it might/could/should have been, most research providers seemed content that commissions were no longer plummeting. Anecdotal evidence from the research providers we speak with suggests that the market environment in 2013 was an improvement over 2012, and for that researchers were grateful.
Will the trend of declining commissions reverse in 2014? After 5 years of declining commissions, surely commissions must bottom. However, it is hard to see what will trigger a revival. If trading volumes can’t be lifted by a 30%+ market, they are unlikely to respond to a more subdued 2014 market predicted by strategists. And, while commission rates have been relatively stable, the prospect of rising commission rates is remote. Nevertheless, for many research providers a ‘meh’ environment is still an improvement over the post-crisis turmoil.
M&A and Consolidation
Acquisitions were relatively robust in 2013, but it remains a buyer’s market with valuations below pre-crisis levels. We are likely to see more activity in 2014, particularly earnouts and partnerships such as Ford Equity Research’s merger with Columbine Capital Services and Cowen Group’s acquisition of Dahlman Rose & Co. It is also safe to say that the ongoing pressures of the research environment will lead to further research exits.
Investment banks have been quietly rationalizing their research departments. Last year’s Institutional Investor poll suggested that Barclays and Credit Suisse weakened their commitment to research while Deutsche Bank and Goldman Sachs were content to tread water. Jefferies, previously a bulge wannabe, shifted its energies to building partnerships with regional Asian brokerages.
Although investment banks may have costs more aligned to current market conditions, the more troubling question is the upside for their equities departments. Investment banks can withstand famines so long as there are feast years. But what if there are no more feast years for equities? This logic may lead to additional bulge bracket exits from equities in 2014, following RBS’s lead. More likely, bulge firms will continue to squeeze their research, hoping that conditions miraculously improve.
Regionals and independents
For regional banks, IPO volumes are a more important bellwether for their research than equity commission volumes since they support themselves on small cap equity issuance. Unlike equity commissions, IPO volume followed the exuberant equity market, up 29% during 2013.
Independent research providers are less dependent on commissions, relying more on subscriptions and having a smaller share of the research pie overall. 2013 seemed a more positive year for independent research as investors again began to seek out differentiated non-consensus research. Post-crisis, as commissions were in free-fall, an increasing share of commission allocations went to the largest investment banks. Now, in a less-stressed commission environment, it appears that independents are winning some of that share back.
A major positive for most research providers–and fundamental providers in particular–has been a shift away from lockstep macro markets. Average correlations of 30% are more conducive to stock picking than the 50-60% correlations experienced post-crisis.
Sector specialists also benefited from last year’s broad market increase where all industry sectors showed gains. The market in 2014 is likely to be more selective in favoring industry sectors, providing challenges for boutiques specializing in out-of-favor sectors.
Other research types
Investment research is highly diversified and the rising market in 2013 did not float all research boats. The improved stock picking market was not a positive for economic research providers, yet macro uncertainties remain for 2014. Economic providers no longer have a gale-force wind at their back, but neither do they face strong headwinds.
For forensic research providers and other short-oriented providers, 2013 was a more challenging year. 2014 offers more promise with increased concern over market levels and valuations.
Political intelligence firms received much scrutiny in 2013 but no regulatory initiatives. It is possible we will see an enforcement action involving political intelligence, but we think the chances are diminished. Mid-term elections will be a slight negative, dampening new policy initiatives. However, underlying demand for insights from Washington will continue.
ESG providers are still waiting for U.S. asset owners to evidence the ESG concerns of their European counterparts. We think ESG is a sleeper category which will find its time in the sun, but it is uncertain whether 2014 will deliver the wake-up call.
Expert networks have rebounded from the panic generated by the insider trading investigations in 2010. The industry is now more concentrated with fewer smaller players, and more diversified geographically and outside the financial sector. Channel checkers and market research firms have also seen improvements from normalizing markets.
The UK regulatory crackdown on payment for corporate access with client commissions will be problematic for primary research providers with UK operations. The UK definition of research eligible for commission payments makes it difficult to pay for primary research with client commissions also. The bigger concern is whether the UK stance on corporate access will be exported to other domiciles.
We will be watching UK regulatory developments carefully in the coming year. We suspect a ban on commission payments for corporate access is a foregone conclusion, even though the regulation is subject to industry comment. A ban would hurt investment banks most: historically 30% of commission allocations have been for corporate access according to the Extel survey.
UK regulatory actions may not stop at corporate access, however. The Financial Conduct Authority (FCA) has questioned whether client commissions should be paid for any research, full stop. At the same time, language in the upcoming MiFID II regulation may similarly impact commission payments for research. Even if regulators pull back from an outright ban, the research market in the UK will be seriously impacted. And these impacts can be felt in other markets if larger investment managers implement revised policies globally.
2014 will bring the trial of Mathew Martoma which starts tomorrow. Assuming Martoma and/or Steinberg do not ‘flip’, the main insider trading show will then be over. There will be a variety of clean-up convictions for smaller fry caught in the quest to nail Steve Cohen, but the forces behind the main investigation will have dissipated.
The SEC’s Mary Jo White says insider trading remains an important enforcement priority, while at the same time trying to set new priorities, such as accounting fraud. The SEC is averaging 50 insider trading actions a year, and this is likely to continue. While insider trading won’t be as headline grabbing, it will remain a compliance priority for investors.