Q&A: The Truth Hurts (your Wallet)

The research used by fund managers is almost always paid for by investors, through the commissions they generate when executing trades with investment banks. The sums involved are substantial. One estimate is that investors are paying $20 billion a year for research.

Yet the conflicts of interest at investment banks are obvious. They have every incentive to publish research which suits their corporate finance business or trading positions or which generates further transactional activity. Fund managers themselves have an interest in placing execution business with investment banks that offer them stock allocations or corporate access as well as research. Which may or may not be valuable. This was why the investigation by former New York attorney general Elliot Spitzer in In the US, the global settlement negotiated by Elliott Spitzer in the wake of the deflation of the TMT bubble in 2001 included provisions to subsidise the development of independent research. It was also why the Myners Review, published in the United Kingdom in 2001, favoured the “unbundling” of research from the payment of commissions for equity execution. This environment has made it hard for independent research providers to compete, since they have to charge for their work and cannot cross-subsidise their research from other activities. The net result is a worrying level of distortion in investment allocation and stock selection. Yet investors are a lot less concerned about this than they should be, according to AN Other, the TK at the European Association of Independent Research Providers (Euro IRP).

MiC: How can your members compete with the resources and access of the investment banks?

PA: To put it simply, independent research needs to be better than the free bank offerings if it is to survive. The challenges lie in making it work as a business. Setting up in the first place, and sustaining the business long enough for revenues to grow is the biggest. Attracting and retaining the talent - in sales as well as research - in a world where the buy-side and sell-side will always pay better is not easy. That is why many independent research firms are partnerships, or are owned by the senior analysts. In fact, some of the most successful independent research houses have been set up by top banking analysts that became fed up with the constraints, conflicts and stresses of working in investment banks.

MiC: How lonely can it get when an independent research house challenges the findings of analysts at major houses?

PA: For passionate, experienced analysts this is not a difficulty. It is their mission. You need to be certain of your facts and analysis - and then courageous in presenting your findings – but independent houses tend to attract this sort of person.

MiC: How hard is it for independent research houses to get a hearting?

PA: All investors, in particular the top institutions, are drowning in information. They need our help to think through and debate our ideas and their concerns. This trusted advisor role, which is unique to independent research, because we have no vested interest to sell them a security, is an important part of the value that independent research firms bring.

MiC: How lonely can it get when an independent research house challenges the findings of analysts at major houses? 

PA: For passionate, experienced analysts this is not a difficulty. It is their mission. You need to be certain of your facts and analysis - and then courageous in presenting your findings – but independent houses tend to attract this sort of person.

MiC: An important source of the power of the investment banks is “corporate access.” How can your members compete with that?

PA: It is a common misconception is that only big banks have “access” to leading companies. Many independents enjoy the same or even better access, since companies need not be concerned with how they are managing conflicts of interest between research and banking or trading. Most companies realise they need to engage with firms that influence market opinion with solid reasoned arguments and deep fundamental research. That is something independent firms need to offer to survive.

MiC: Regulators have shown interest of late in both corporate access and expert networks. Are regulatory moves helpful to independent research houses?

PA: Corporate access should be more tightly regulated. Sometimes, firms covered by an independent research provider appear at conferences organized by large investment banks, and the independent research house is not granted access. This can limit the ability of independent providers to provide accurate information to clients. In the credit markets, prices are not publicly available. Any regulatory change that would lead to a more timely publication of market prices would help independent research providers to better follow the price moves happening in the markets.

MiC: How are fund managers paying for independent research?

PA: There are multiple mechanisms that institutions can use to pay, from simply writing a cheque, through Commission Sharing Agreements (CSAs), to Directed Commissions. Access to CSAs has been a major driver of the take-up of independent research. There is a clear acceptance among equity investors in the United States, Canada and the United Kingdom that receipt of idea-generating research, and in particular incoming analyst calls or visits, is a valuable service that must be paid for. The CSA concept is less used in some countries of continental Europe. The Germans are the most advanced. In Asia payment is more often by directed commissions than by CSA. One might call this the old-fashioned way, akin to soft dollars.

MiC: Are your members selling mainly to larger fund managers?

PA: The bigger firms lap up a lot of independent research, because they have greater internal bandwidth. The smaller, long-only players have more limited resources. Some content themselves with broker research, precisely because it offers them the “comfort” of knowing that they will be told what security to buy. It makes their lives easier.

MiC: Are some types of manager and some types of investment strategy more interested in independent research than others?

PA: The simple answer must be “yes.” Hedge funds have very different requirements to conventional long-only managers or pension funds. Some hedge funds are trading or quant-based. Long-only players tend to be stock-pickers - or bond or credit pickers - with varying time horizons, but mostly rather longer than hedge funds. In the major centres such as the United States and the United Kingdom - and Canada, for that matter - we come across the whole spectrum of styles. In fact, the growth at pension funds in the United Kingdom and Canada of tactical asset allocation teams that act more like hedge funds – looking, for example, for poorly correlated trades - has increased their appetite for idea generation through independent research. Funds of that kind in the United States have a greater tendency to employ industry analysts in house. In Asia the number of styles is growing as more and more sophisticated managers move in, but it is still a much simpler world than the United States.

MiC: Does that relative lack of sophistication in Asia make Asian managers less interested in independent research?

PA: In Asia the focus is on Asian stocks of course. There is a bit of “not invented here” in Hong Kong. But investors in Shanghai think the Hong Kong people are too far from the action to make sound judgements. In the United States and Europe there is a greater openness to independent research, which stems from an admission that “we know enough to know that we do not know.” When it comes to their research needs, institutional fund managers in the United States and the United Kingdom have a strong world view. They absorb multiple feeds in order to better inform their investment process. These feeds are at several levels, including fundamental (for example, macro- economic research), primary (research from industry consultants, expert networks and channel checking, or researching stocks by examining their distribution channels) and orthodox stock research based on financial analysis and talking to management.

MiC: How hard is it for independent research houses to survive?

PA: Relationships are critical. If your main client is fired, or they close down the team, or a credit crunch or fiscal cliff intervenes, your business is vulnerable. Sometimes it is possible to follow an individual client from one firm to another. Mostly however we fan out from our point of entry and try to build a broader base of support in the client firm. Once you have built the relationships you can still face a battle to get their middle or back office to pay you. So it is important to get on a plane and go and see people, and persuade hard-to-meet institutions that it is worth them taking on yet another provider of research. But the real secret of success is delivering an excellent product.