I was asked last week by the head of a large North American fund how he could sanction the use of paid research in one team and not across the board.
I’m surprised by the mere fact this question needs to be asked. Surely a fund manager’s primary responsibility is to attain the maximum value of their portfolio through the experience and skill of the manager, while utilising the best data and cost-effective analysis to their advantage? In the case of my conversation, I respect that he was just trying to justify why he needs to introduce a new cost base when research has for decades been provided “free” from investment banks.
And that is why I have been inspired to write this article.
You pay for what you get!
To set the scene, at the beginning of last year European Regulators (including and led by the UK) turned the investment research industry upside down by forcing investment banks to set a price for their research separately from their execution services. For as long as can be remembered, research has been delivered as part of execution commissions. Many North American or other Non European centric funds remain free from the extra costs – ironically, in my opinion, this is to their and their clients disadvantage!
Firstly, what is the definition of research? The Cambridge English Dictionary is quoted:
A detailed study of a subject, especially in order to discover (new) information or reach a (new) understanding
The Cambridge English Dictionary
My interpretation of this, in a practical sense for fund management, is that I would want the best analyst with zero bias to discover any information that would lead him/her to reach a decisive and independent understanding of the subject.
The finance industry attracts some of the most talented people and provides significant added value to virtually all parts of the world economies including government, not-for-profit and corporate. The depth of knowledge inside research departments is something that should be preserved, but we are seeing a brain drain of significant proportions for multiple reasons. Brokers have been under constant margin pressure in recent years caused by changes in their business model, resulting in layoffs. This particularly affects research departments and has had an inevitable impact on coverage capacity.
Provision of research is a critical part of the stock market eco-system. Large and mid-capitalisation companies enjoy coverage from multiple sell-side brokers which is recognised as high quality, free of bias and serves the fund management industry well. In the smaller capitalisation world, particularly the capital hungry sectors, provision of research is used as a powerful tool to encourage corporates onto the bank’s client list. It is here that the purpose switches from client value-add to bank benefit. But equally, without research, listed companies are bereft of suitable debate and marketing presence to encourage investors to invest.
The decision by Regulators to go down this highly controversial route was baked more in the need to force transparency over costs to unit holders than anything else. But it is the unintended consequences that will over time create positive opportunities to those that fully embrace the changes. Before the rules changed, research budgets hardly existed. As such, boutique independent (equity) research couldn’t compete.
So, in the world of smaller companies, we have a number of competing forces at work that influence supply/demand of research. Demand for capital by corporates, reduced research coverage, pressure on broker margins and increased focus on active fund managers for enhanced performance.
Brokers have monopolised research to fund managers for decades. Changing this culture is difficult. Regulatory forces are a blunt instrument to force change and it will only be over time when new sources of analysis can prove reliable and find traction.
There can be no doubt that reading a well-structured and thought-provoking analysis, known to exclude bias or ulterior motive other than to reach a new understanding, has infinite benefits to the reader. Success is no longer measured by the broker’s corporate department to satisfy their own client, but by the analysis it uncovers or the prediction of an event in the future. The author has no concern whether his/her writing upsets other conflicting interests. Conviction of an argument is far stronger, the depth of analysis to attain this conviction is deeper and by contrast the document is not a marketing tool but a document to support a decision that should lead to enhanced fund performance. Equally, if proved correct, the author will enhance his/her reputation and gain a greater following and ultimately no doubt charge more for their future research.
…reading a well-structured and thought-provoking analysis, known to exclude bias or ulterior motive other than to reach a new understanding, has infinite benefits to the reader
If there was ever an example needed to prove the above it is in the small/mid-cap environment of high-risk sectors such as mining and biotech. Both are highly complex requiring significant input of science to develop and ultimately de-risk process’ to ensure success. Both sectors compete for expensive capital to explore and develop their dreams. Financial institutions play an important part in connecting these companies with the necessary capital and use their published research as a tool to attract both the underlying corporate as well as the potential investors. Valuing a company or its assets without full understanding of the technical risks, as is common practice in these complex industries, is pointless – particularly when failure in these sectors is ever present and typically fatal for equity holders! At this end of the stock market there are few research reports that have a “Sell” banner!
Ask yourself if you would follow the lead of one of two research reports:
- written by an analyst at the investment bank that is raising significant funds for a commission for the company in question
- written by an equally experienced independent analyst, who only has the end user as their client to consider
If you agree the second approach is sensible then it goes without saying that the research needs to be paid for by the user, the fund manager!
‘Research’ is simply a tool. Just like anything it can either be high or low quality. “Free” research monopolising investment consideration, such as that explained for smaller companies, undermines the value that ‘Research’ can provide. It limits competition and restricts the ability of independent thought to uncover new ideas. In science-based sectors it also restricts non-technical persons from deciphering the complex professional studies that form the basis of corporate strategy, financing and market promotion. This leaves these sectors in the realm of “too complicated” and paralyses them from accessing wider capital pools, thus negatively affecting valuation.
New forms of research, if incentivised, will fill the void by addressing weakness in the system and provoking independent thought. This will lead to improved risk mitigation, enhanced execution and the identification of additional opportunities. Genuinely independent research is a tool for the greater good, let it express itself!
