A typical caricature of an investment banker is an expensively besuited man with a briefcase, Breitling watch and mobile phone, evoking an image of wealth, refinement and arrogance. It’s not a man wearing a camel-hair coat and a lot of gaudy jewellery. But perhaps it should be since the business of a banker is akin to that of the stereotypical second-hand car salesman in London’s East End. Both banker and car dealer preach quality and respect for the client but both are middlemen, squeezing profit from the two sides of a trade.
Investment banks want both corporates and investors to like them. But if you try to please both sides, you are likely to end up contradicting yourself and getting entangled in conflicts of interest.
That’s why institutional investors have long been wary of sell-side research. New York’s attorney general Eliot Spitzer may be drawing more forces into his crusade against biased research – he has now shamed the SEC into action. Analysts putting a buy rating on a stock while in private trashing it have set themselves up as easy targets. But there’s little new in this, other than that in the late 1990s’ bull market retail investors were more prominent than for 30 years, often taking at face value research created for a different audience. They can rightly feel hoodwinked.
Institutional investors have deeper questions to be asked about sell-side research than whether it is biased or not: is it any good at all and what is it worth? As to bias, institutions have had much to lose by crying foul. Investors want preferential treatment from banks to get new-issue allocations but that implies a relationship. To build that they need to trade, and paying for research has been bundled up into trading to such a degree that institutions can barely quantify what they’re paying for research or say whether it is useful.
Benn Steil at the Council for Foreign Relations in New York recently surveyed chief investment officers or head equity traders at 72 asset management firms in the US and Europe. One would expect buy-side traders to be the main voice in where to place trades. Not so: 40% of the time it is a portfolio manager, 12% buy-side analysts, and 10% clients. That strongly implies that trading is done to reward other services.
Steil says it is in a fund’s best interests to hide non-trading costs in the trading costs. Making explicit payments for research and support, or setting up such operations internally, would involve higher management fees. So much for best execution.
This is beginning to change. With stock markets still performing poorly, higher trading costs are more visible. Hence more and more asset managers are exploring direct trading through electronic commission networks or crossing networks.
If the cost of research becomes apparent, its quality must improve. How? At a time when so many stocks have been driven down by deteriorating credit fundamentals, equity analysts continue to look at earnings projections far more than capital structure. It’s bewildering that company reports don’t combine debt and equity analysis.
Research must reinvent itself.
