In just a few years, the business of institutional investment research has gone through seismic shifts. These shifts have been prompted in part by the exposure of tainted recommendations and conflicts of interest among research analysts on both sides of the Atlantic. In some cases, analysts were not only expected to deliver opinions about industries and companies, they were also trying to bring in lucrative underwriting business by giving favourable reports.
In the UK, Paul Myners’ review of institutional investment practices concluded that fund managers had an incentive to direct business to brokers in order to obtain additional services, rather than seek the most favourable trade execution terms for their customers. The Myners review made two fairly radical proposals to reform this system. First, it proposed that research be paid in hard currency by the asset manager, and not through the use of directed commissions. Second, it proposed that commissions be paid by asset managers and not by the clients.
While investment professionals in Europe were analysing the Myners’ proposals and multi-million dollar fines were being assessed in the US, the investment markets were having a hard time recovering from the downturn that began in early 2000. As a result of these regulatory and market pressures, many large investment houses cut staffing levels, particularly in their research departments. Today, if these people have not left the business altogether, many of the analysts are being hired by buy-side firms that want to do their own research, while other analysts are forming their own independent boutique research firms.
It is too early to say where all this will lead, but in one likely outcome, it is expected that more and more research will be paid in hard currency, while some research will continue to be paid through commissions. Although commission-funded research seems unlikely to be prohibited, it will probably come with significant requirements for disclosure to clients and government regulators.

Despite these developments, one important characteristic of investment research has not changed very much: while the conclusions of research analysts are, in most cases, based on extensive study of available information, including balance sheets, income statements, competitive positions and industry outlooks, the analysts’ buy and sell recommendations are, in the end, opinions, not facts. And, of course, different analysts can evaluate the same information and arrive at very different conclusions.
Institutional money managers are looking for ne ways to help guide their investment decisions; they can be expected to gravitate toward fact-based, rather than opinion-based research. One fact-based system ‘follows the money’, that is, it focuses on global portfolio flows to analyse investor sentiment and behaviour.
To see how this system works, imagine two ways of analysing the outlook for the semiconductor industry. Using the opinion-based system, an analyst will gather volumes of information about the markets for this industry, including demand and expected sales of computers, mobile phones, global navigation systems, video games, industrial equipment and any other devices where semiconductors might be used. The analyst will talk to manufacturers, distributors and customers of these devices. Ultimately, however, the analyst’s outlook for the semiconductor industry will be an opinion, albeit one supported by thorough research in most cases.

An alternative method, and one being used by an increasing number of investment professionals, does not rely on opinion. Instead, it looks at where large institutional investors are putting their money. This fact-based method can not only pinpoint increased - or decreased - confidence in particular countries or industries, it can also measure investors’ expectations toward the economy. For example, if a consensus of institutional investors believes that an economic slowdown is approaching, they might be expected to move assets away from cyclical sectors such as materials, as well as industrials and consumer cyclicals: or, if investors expect medium- and long-term interest rates to remain relatively low and stay that way for a while, they can be expected to rotate toward financial stocks.
Still, it should be pointed out that fact-based analysis of capital flows is not a total replacement for opinion-based research. Once particular sectors have been identified as having favourable outlooks, traditional research techniques are still needed to identify which companies within those sectors should be added to a portfolio.
The ability to track flows of money in and out of particular sectors is, of course, a valuable tool. However, money managers today also are looking for a broader picture of the investment environment. For that, they can turn to another element of fact-based research: investor confidence.
Investor confidence receives considerably less attention than consumer confidence. Generally, investors are said to be confident when news about the future is good and prices are relatively high. However, higher prices typically have more to do with good fundamentals, such as rising industrial production, rapid productivity growth, business fixed investment, and low real interest rates rather than the underlying sentiment of investors.
Investor confidence can be measured directly and quantitatively by monitoring the movement of the trillions of dollars of global investable assets, then measuring investor holdings of assets or sectors that appear to carry greater risk at a particular time. As investor confidence or risk appetite increases, they become more willing to devote a greater share of their portfolios to riskier investments. They also become more willing to invest in industrial sectors that appear to carry greater risk at any given time. By the same token, when investor confidence begins to decrease, money is moved away from riskier assets and toward assets that are seen as less risky.

The most dramatic fall in investor confidence in recent years occurred in August 1998 when Russia defaulted on its debt, the large global hedge fund Long-Term Capital Management failed and stock prices fell. While market fundamentals remained relatively strong, a lack of investor confidence brought stock prices down. Investors simply did not want to hold as many risky assets during that period
More recently, investor confidence deteriorated in the summer of 2002 on concerns over accounting standards, corporate governance, and regulators’ handling of accounting reform and commission-based research. Again, the initial fall in confidence was accompanied by declines in prices, but confidence remained low for the rest of the year while security prices stabilised.
If the investment industry has learned from the experience of the past few years, independent, fact-based research is in an excellent position to win an increasing share of the institutional market from opinion-based research. It is one thing to say where investment assets ought to be going; it is quite another to actually pinpoint where money managers are investing their money.
There will, of course, always be a place - indeed, a need for - for the experience and judgment of individual analysts’ knowledge and opinions. However, the need for unbiased, fact-based analysis that continually identifies flows of capital in and out of industry sectors, while monitoring investor appetite for risk, is becoming more apparent every day.
Nicholas T Bonn is executive vice president and head of securities trading at State Street Global Markets

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