The value attached to equities research by institutional investors is under the spotlight again as the market prepares itself for another jolt of disruption, especially within global equities.
Since the introduction of 2003’s ‘Global Settlement’ – a Securities and Exchange Commission (SEC) judgment aimed at correcting market abuses and issues related to conflicts of interest within the equity research houses of US investment banks – there’s been relative calm in a section of the capital markets not known for harmony.
Yet one of the key outcomes of the SEC judgment, which required the investment banks to make payments of over $430m (€277m) to fund independent research for investors, ends next year, and potentially so do the hopes of a number of independent houses operating in the equities research space.
“An important feature of the settlement was that participating investment banks, such as Merrill Lynch and Morgan Stanley, should provide research from independent sources alongside their own, as a sanity check and to rein in any unwarranted enthusiasm,” explains Shane Smith, chairman and CEO of Independent International Investment Research. The absence of any scandals in sell-side equity research so far demonstrates that the 2003 judgment has had the desired effect, he believes.
But in recent months, there has been evidence that the general good feeling in the marketplace is beginning to evaporate. A number of ‘indies’ have voiced concerns that, in addition to their revenues taking a hit as a result of the settlement period ending, institutional clients will suffer from a decrease in equities coverage, particularly in global and niche stocks.
A recent study by Thomson Financial showed that as sell-side analysts have left the industry, research produced by the banks is 20-30 per cent less than in the days pre-settlement. Another report, from Greenwich Associates, found that while equity analysts at buy-side firms are ramping up their use of independent research, these institutions are not increasing the amount of commission paid out to third-party research providers.
The Investorside Research Association, which represents independent analysts, forecasts that the highly fragmented research markets will become even more fragmented as investment banks continue to squeeze their research headcount because of tougher markets and balance sheet haemorrhaging caused by the credit crunch.
“Without further intervention, when the settlement ends there will be a return to the status-quo in the industry but with less research produced and no ‘policing’ to keep research practices in line,” warns Mr Smith.
With $430m in subsidiaries effectively being pulled out of the industry next year, global equities coverage could be the first to suffer, many in the market forecast, yet this is where investors seem to be demanding coverage the most.
Money for nothing
One stand out issue is that the coverage and research of global equities is essentially a loss leader for investment banks. “You have a classic conundrum: banks want to cover stocks where they get meaningful business, but this is where we on the buy-side need the least help,” says Gunnar Miller, co-head of global research and European equity research at RCM, the global equities platform of Allianz Global Investors.
Mr Miller, who runs a team of 40 analysts with many recruited from the sell-side, believes coverage of global stocks has become diluted in recent years as the structural shift to fragmentation continues and sell-side units remain largely underfunded. “The buy-side is ascribing less value to traditional sell-side research than in the past, though some flavours of it remain valuable. However you can still get scenarios where we've 55 broker reports on Vodafone produced and crowding our screens. Couldn't a few of these analysts written on a Greek bank, or an exciting small cap IPO in emerging markets?” he asks.
Malcolm Kemp, head of quantitative research at Threadneedle Asset Management, views the revenue model behind global equities research – or specifically a lack of it – as to why the momentum of the early 2000s failed to catch on. According to Mr Kemp, most brokers initially expressed enthusiasm to think 'global' and set up global desks: “We now suspect a number of brokers have found it difficult to make global research pay in terms of commission flows, and it's disappointing the early momentum didn't to catch on,” he says.
And these buy-side suspicions are largely correct. “There's been a long-term trend of squeezing commission rates, so who's paying for equity research these days? In the late 90s it cost $1bn to run an research unit and this is a tremendous overhead even for a bulge bracket bank,” explains Shane Smith, now an independent but with a decade's experience at a bulge bracket investment house.
