It is always nice when things turn out better than expected. One of the concerns about Mifid II (the updated markets in financial instruments directive), introduced at the start of 2018, was that a requirement to be explicit to clients about research costs would lead to a scaling back in analysis. Mooted potential consequences were a reduction in small-cap coverage, adversely affecting the ease with which they could be bought and sold. It is still early days, but research by Scott Evans, Paul Marsh and Elroy Dimson of the London Business School (LBS) has shown no such effect on market liquidity.
As part of the annual review into performance drivers of the Numis Small Companies Index (NSCI), the LBS academics found that, although equity research has fallen by 8 per cent since Mifid II, so far there is no disproportionate reduction in small-cap coverage. In any case, all market size segments have seen both higher volumes and greater turnover of trading in the past year.
This may be to do with factors more powerful than the level of equity research, though. The second chart shows trading velocity (measured as the number of times average market cap is turned over in a trailing 12-month period) on the London Stock Exchange (LSE) before, during and after the financial crisis; and the difference either side of the 2007-09 bear market is stark.
Turnover relative to market cap increased prior to the financial crisis, which the professors explain is the general trend in a bull market when trading volumes tend to be higher. They also say that the spike in velocity in the immediate aftermath of the crisis is because the market value fell considerably more than trading volume, which makes sense in a violent sell-off. What is interesting is how trading velocity has been subdued since the nadir of March 2009, during a sustained period of rising share prices.
Quantitative easing (QE) turbo-charged the early stages of the long bull market and blue-chip momentum became the only trade in town. This saw a much lower velocity of trading in small and mid-cap shares relative to before the financial crisis, when investors engaged in more diverse activities such as long-short hedging, risk arbitrage and event-driven strategies. The academics say: “We know that the proportion of total volume accounting for small- and mid-caps has been falling as the market has become more concentrated. The concentration of turnover peaked in the 2009-12 period when as few as 59 companies accounted for 80 per cent of total market volume.”
