Brokers used to employ an army of analysts to read the company reports for you. A row over who’s going to pay for them may put an end to that. Simon Wilson reports.
What’s the issue?
The longstanding model of “sell-side” investment research – ie, research conducted by investment banks and brokerages and sold to “buy-side” investor clients – is under pressure. For decades, banks and brokerages have employed small armies of clever analysts to go though the minutiae of corporate balance sheets (or decipher central-bank speeches, or predict the prices of copper and tin, or whatever). But cost and transparency problems mean that the sector is facing radical change. Although analysts are paid less than star traders or mergers and acquisitions experts, say, their contribution to the bottom line is by its nature hard to quantify. As in the news media industry, there is an intense debate with banks over how to “monetise” their content.
What about transparency?
For years, asset managers have usually received research as a “free” add-on in exchange for using the investment bank or brokerage to carry out trades. So the trading and research costs have been bundled together into a single fee, whose constituent parts are opaque. Such a set-up risks conflicts of interest. After the dotcom bubble (an era in which there were numerous examples of analysts ramping worthless tech stocks to win deal business for their banks), stricter regulations have limited the ability of analysts directly to drum up business.
And from January 2018, under new EU financial market regulations (known as Mifid II) asset managers will be obliged by law to budget separately for research and trading costs (a change known as “unbundling”). That means that banks and their clients are currently locked in fierce negotiations over what the research is worth and how much fund managers will have to pay. Some banks, according to sources quoted by the Financial Times, are demanding up to $10m a year to access their research platforms, with more for add-ons such as face-to-face meetings with analysts.
What will this mean for investors?
For some it is likely to mean higher fees: more than a fifth of fund managers plan to charge investors an extra fee to cover research costs, according to a survey by RSRCHXchange, an online marketplace for institutional research.
Many fund managers haven’t yet said how they plan to address the issue. And some, including quite a few big-name fund managers, have pledged to absorb the cost of paying for external research themselves. Neil Woodford, Baillie Gifford and Prudential-owned fund house M&G all announced last year that they would stop passing the cost of analysts’ reports and brokers’ notes on to clients. And last month Jupiter followed suit, its chief executive Maarten Slendebroek arguing that the move would give the company a “competitive advantage” over its rivals.
How useful is research anyway?
It depends how it is used. When it comes to making investment decisions based solely on “buy” and “sell” recommendations, investors should be extremely wary. One recent study by AJ Bell, the stockbroker, found that the ten FTSE 350 stocks most popular with analysts in January 2016 – all with “buy” ratings – returned an average of 2.1% over the course of the year, far less than the overall index, which was up by 12.5% The ten least popular, by contrast, returned a mammoth 56.2%. It was a similar story with FTSE 100 buys and sells.
Moreover, numerous other studies have found that analysts routinely have an overly rosy view of the companies they cover, and that “buy” recommendations vastly outnumber “sell” recommendations, even when the market is heading for a crash. In January, just 6% of the roughly 11,000 recommendations on US stocks in the S&P 500 were sell or equivalent ratings, according to data cited by The Wall Street Journal. In 2013, a survey on the personal finance website NerdWallet found that even on the 30 biggest US stocks, 49% of analysts ratings over the course of the year were wrong.
Why are analysts’ predictions so bad?
There are several good reasons why analysts get it wrong so much, argues Sarah Gordon in the FT. Much of the time, analysts are recommending “glamour” stocks, with positive momentum and news flow, high growth and high volume. But unsurprisingly these also tend to be the most expensive stocks; analysts are often simply jumping on a bandwagon. Secondly, analysts are as guilty of groupthink as anybody else. “Being an outlier and wrong is much more painful that being close to what everyone else is predicting and wrong. This discourages originality of thought and means convergence to the consensus is the norm.”
Finally, there’s another in-built incentive for analysts to be optimistic: an increasingly big part of their job is to facilitate access to corporate executives on behalf of their clients, the fund managers. Such access becomes much harder to secure with a “sell” recommendation.
The future of research
There may be less of it: some asset managers are bringing research in-house, and overall spending on it is expected to fall – by up to 30%, estimates a study by Quinlan & Associates. The other big effect of the clampdown will be to level the playing field between the big banks and small, independent, “boutique” research specialists gaining a foothold in the market. “The whole industry is basically a scam,” says Mark Hiley, founding partner of independent research provider The Analyst. “There’s about twice as many sell-side analysts as there needs to be, paid twice as much as they need to be”, he told the FT last month. “This Mifid II thing will completely decimate the sell-side: it’s going to provide price transparency [so] independents will appear much better value than the incumbents.”