How to pay for research is one of the toughest riddles on Wall Street. The challenge, says Smith Barney’s director of global research, Bill Kennedy “on a global scale as well as in the US, is to take the talent we have and find a way to package it that is both investor-friendly and commercial”.
The 2001 report by Paul Myners commissioned by the UK Treasury to look into institutional investment decision-making has played a big role in focusing attention on the issue, as it is forcing firms to unbundle research costs from trading costs. “That’s made all of us, on both the buy and sell sides, assess just how much we pay for research and what we get for it,” says Kennedy.
The investigations into sell-side research by New York attorney general Eliot Spitzer brought that assessment into sharper focus, as it had an immediate impact on research budgets. Brad Hintz, brokerage analyst at Sanford Bernstein, estimated in October last year that Spitzer’s plans to bar underwriting and advisory revenues from subsidizing research, which came into effect this year, would knock 23% off US direct research budgets.
Banks have drastically cut back on the number of analysts and the number of stocks covered as a result of that and the general downturn, and there could be more cutting to come, according to some bankers. Banks have also cut back research bonuses.
They might have to cut even more as equity markets revive, because equity trading revenues will be able to take up even less of the slack than originally hoped, according to a report Hintz published at the end of August.
Hintz wrote: “It wasn’t trading volumes. Both NYSE and Nasdaq volumes actually increased over this period so it wasn’t a simple capacity issue. It was a series of structural changes in North American equity markets: the growth of programme trading, decimalization, the decline of Nasdaq profitability and the growth of ECNs.”
Falling revenues
Hintz then revisits his earlier figures for research budgets, estimating that the $2.7 billion a year the investment banks were spending on research before Spitzer would probably fall a further 12.6% as a result of the decline in equities revenues, which equates to a drop of $1 billion in total.
The banks are still working out what to do. One at least has introduced a spearate P&L account for research. “Research isn’t just a cost centre,” says the firm’s global head of equities research. “If it were, no-one would have analysts, so there must be value there. We’ve spent a year working on that. It’s already in place in Europe, will be in the US this month, and in Asia by the end of the year.”
Smith Barney hasn’t gone as far as that, but isn’t so distant: “I’ve spent much of my time on strategic analysis of all our equity research worldwide,” says Kennedy. “We’re looking at sectors, total cost of sectors and regions, as well as addressing the value added. It’s a much stronger budgeting process.”
If banks’ research departments disappeared, investors and banks themselves would surely miss them badly. But investors won’t suddenly start paying more for trades, and seem unwilling, according to a recent Greenwich survey, to pay extra for research.
For as long as that remains the case the riddle will be unsolved.
