Warren Buffet once famously remarked that analysts’ reports meant nothing to him. Last year’s scandal highlighting the bias of much of this research will have swollen the ranks of those that agree. Yet all the publicity simply highlighted was a problem that pension fund managers were already aware of a flaw in the investment bank/research model.
Unfortunately most have to rely on brokers’ equity research, at least as a crutch. They’re unable to launch their own as its too expensive and they’re unable to buy it as it doesn’t exist. Furthermore their commissions paid to investment banks are overshadowed by those of corporate clients so talk of separating research to introduce objectivity is nonsense so long as the two remain within the same profit centre.
Roy Peters, head of Aerion Fund Management in London, formerly the £10.3bn (E14.4bn) British Gas fund, says the focus of analysts and stockbrokers changed as far back as the mid-1980s with the big bang and the acquisition of brokers by the large investment banks.
“Inevitably with those banks making more money out of M&A activity and new issues compared with commission from the likes of ourselves, it’s not surprising that the focus of analysts has moved in that direction and away from institutional clients,” he says.
Which raises two questions- how do pension funds get the best out of existing sources of information and what is the future for brokers’ research? Pension managers agree that, if you ignore recommendations and acknowledge potential bias, there remains a wealth of useful information within the research.
Stuart Colley, investment manager at the £9.1bn Corus fund, says: “we know that the big fees come from the corporate side where they are basically selling shares. We use brokers for information, for industry knowledge and for opening doors to companies because they do give us access. Never mind the recommendation, just take the information with the knowledge that some of it may be somewhat slanted and come to your own conclusion.”
Troels Gunnergard, chief investment officer of PKA, the DKN8bn (E1.08bn) Danish pension fund, says portfolio managers double up as researchers and use broker research selectively. “There’s still a lot of useful information in the broker research- data, company information and so on. At the end of the day though, the responsibility lies with us and we have to make our own decisions.”
Says Peters: “what’s important is the information about what’s happening in the industry and the companies, not the recommendations. If there were no recommendation, it wouldn’t bother us at all. The only ones that are any good are when a broker is encouraged to say ‘this stock is overvalued’. Now that you do pay attention to.”
The knee jerk reaction to the shocking emails that led to a $100m settlement between Merrill Lynch and New York Attorney General Eliot Spitzer last year was that research divisions needed greater independence or total separation. This reaction gained further impetus last month with total fines of $1.4bn levied on some of the biggest names in banking.
But this misses the point and is a strategy most feel goes little way to solving the problem, if a recent Greenwich Associates survey is to be believed. It quizzed 50 US institutions, each with over $20bn in assets, and reached an apparently contradictory conclusion. The majority of those interviewed gave strengthening existing Chinese walls as the best means of reforming sell side equity research.
A remarkable two thirds then went on to say restructuring equity research would not improve the independence or quality of sell side research. “That’s a fairly significant number saying that whatever the banks do to restructure equity research, there are still going to be problems,” says John Webster, a consultant at Greenwich.
A third backed the totally improbable separation of equity research from investment banks so as to produce independence. A small group said they would prefer an in between solution whereby investment banks would fund independent research for retail investors while ‘ring-fenced’ research would be maintained for institutional investors.
(As part of the latest settlement 10 investment banks, among them Citigroup, Goldman Sachs, Merrill Lynch and Morgan Stanley, have been forced to put aside a combined $433m to fund independent research).
All of which gets marginally less than short shrift from pension fund managers. Colley sums it up bluntly: “all this nonsense about funding independent research. They’ve got to do a few things to try and salvage their tarnished reputations. It’s not going to solve the problem of course, they’ll soon be back to their own ways.”
Jan Willem van Oostveen, senior portfolio manager at PGGM in the Netherlands, says they are forced to use broker research for lack of an alternative. Echoing PKA’s Gunnergard, he says they digest as many brokers’ reports as possible and then “try to filter out all the biases.”
There are, he says, two alternatives, one unrealistic, the other likely to be less than satisfactory. Large and totally independent research companies, capable of squaring up to large investment banks are, in his opinion, desirable but ultimately Utopian.
“Of course everybody is going to be in favour of this. It would be an ideal situation but how do you go about this in practice? First, you have to start with a very large group of analysts that is going to be able to compete with the likes of Goldman Sachs.
“Then there’s the issue of what type of person you’re going to be able to attract and how much you’re going to be able to pay them. Then you have to rely solely on monthly fees.”
The second alternative- creating an in house research department- can itself produce a conflict of interest. Says van Oostveen: “it raises the question of who is running the portfolio. If an in house analyst recommends an equity and it happens to be one that the manager dislikes, who ends up having the final say?” Then there’s the cost of launching such a department.
And it’s due to this prohibitive expense of funding independent research that most funds find themselves in a bind. Two thirds of senior managers surveyed by Greenwich said they plan to maintain both their current in-house equity research staffing levels and their existing reliance on broker research. Only one in five interviewed said they will increase their in-house staff and rely less on the sell side for their research.
One effect of the Spitzer-Wall Street showdown is that some of those funds relying on external research are switching to smaller, more independent brokers. “The whole episode has reinforced the fact that good independent research is of great value. We certainly look to use independent research as much as we can, particularly small brokers. Those that don’t have a big corporate axe to grind are becoming more attractive,” says Colley.
Peters says that in the US, 90% of its commissions are with half a dozen brokers, three of whom, including Prudential and First Manhattan, are independent. “We’ve skewed our business towards people who like the old model of a more traditional agency broker who looks after its institutional rather than corporate clients. There’s just more objectivity to it,” he says.
Many of the more experienced analysts are leaving large investment banks and either joining smaller, recently-established broking firms or are getting backing from venture capital companies and setting up on their own.
The last 10 years or so has seen a spurt of independent, old-style agency brokers. Launched almost 12 years ago, Collins Stewart has become an enormously successful broker and now deals with 250 of the UK’s largest institutional investors.
Other success stories are Numis Securities, which recently hired a number of highly-rated analysts, and Bridgewell securities, an independent research-based stock broker, launched less than a year ago. Bridgewell managed to recruit Richard Jeffrey, chief economist and former head of research at Charterhouse Securities and Neil Kirton, a former global head of equity sales at ABN Amro.
As for the launch of companies specialising solely in independent equity research, there is nothing nor does there appear to be anything in the offing. “It’s a very expensive thing to do to launch an independent research boutique,” says Peters. The economies of scale required to make in-house research viable are vast- Aerion has half of its £10.3bn in equities, yet Peters maintains this is still insufficient to justify a new team.
At the top end of the market, however, some of the largest fund managers have ploughed money into their own research. “We’ve seen that already with the large American fund management companies like Wellington and JP Morgan. In the UK, people like UBS, Flemings and Barings have been developing their own teams,” says Peters.
And as to whether there is going to be truly independent research available in the future is open to debate. Another UK pension fund with around £3bn in assets has a budget to buy independent research. “We’d love to buy in research but there’s very little quality available in terms of individual stock research,” it says.
Peters says his fund would certainly be interested in independent research on individual companies. “The question is whether there are enough people out there willing to pay hard cash for the research. I guess we would be but it’s a question of chicken and egg.”
And again, the evidence suggests that good quality, independent equity research would find a market. Small independent companies offering economic, strategic and asset allocation analysis are flourishing. Andrew Smithers’ Smithers & Co, which provides asset allocation advice, and Roger Bootle’s Capital Economics are gradually increasing the number of pension fund clients. As is Gaveco, the economic research company launched four years ago by Charles Gave.
Peters says removing broker recommendations may go some way to solving the fundamental problem. “People aren’t then having to write buy recommendation because it happens to be a potential client.” But for others, independent research is the real solution. As one manager outs it: “At the moment most researchers are not paid to do good forecasts, they’re paid for marketing. What we really need is more independent research. It’s the direction the market is going to go but it’s not an easy step to make.”

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