Part one of a three-part series reflecting on the decline of the sell-side business model
The list of the fallen in US sell-side equity research grew longer in the past 18 months: BB&T, Brean Capital, CLSA, Nomura, Sterne Agee/CRT, and my former employer, Avondale Partners.
Global investment banks are spending about $3.5 bn this year to fund equity research operations, compared with more than $8 bn in 2008, according to Frost Consulting. Over the same span, about $1 tn has flowed out of active asset management in the US, most of that being captured by passive strategies such as indexing. Passive funds are approaching 50 percent of US fund assets under management, as calculated by EPFR Global. That figure was only 30 percent in 2010.
A key driver of this shift toward passive investing is the growth of the investment advice industry. Retail stockbrokers have been replaced by fee-based financial planners and advisers. Instead of being paid on trading commissions, financial advisers earn fees based on clients’ assets under management. This important change makes advisers sensitive to trading and investing costs – and, naturally, advisers love the low cost and easy value-add of index funds and exchange-traded funds.
In other words, actively managed funds are at a marketing disadvantage, as the universe of retail financial advisers – growing at a compound annual growth rate of 5 percent, according to the US Bureau of Labor Statistics – pushes passive.
Business media love to bash sell-side research, but regardless of the product’s qualitative limitations, nobody should wonder why the industry is in serious decline. Money spent on research is a direct function of actively managed assets under management, and this alone is enough to explain why the equity research industry is about 40 percent of its pre-Great Recession peak.
Playing a major role, no doubt, has been the decline of equity capital markets activity: there were only 105 initial public offerings in 2016, the lowest since 2009. Secondary offerings were similarly depressed, as equity capital remained expensive compared with the miniscule cost of debt financing.
Why does sell-side equity research exist? If one believes the tales told by The Economist and the Financial Times, sell-side research aims to shill for the stocks of investment banking clients, foment churn in other equities (to be monetized in the form of trading commissions), create corporate access events, and perhaps bring fund managers some information about companies and industries.
My career has been almost evenly split between buy-side and sell-side research; I’ve been a creator and a consumer. Based on my history of doing and using equity research, I have four main conclusions about the business.
1. Sell-side research remains plagued with conflicts of interest
The collapse of equity trading commission rates (competed down to nearly zero) and trading volumes (diminished by the decline in active management and the extinction of retail stock brokerage) wounded the broker-dealer business model. But the meager activity in equity capital markets is crushing it.
Most broker-dealers had tried to operate sales, trading and research close to breakeven, with profits coming from investment banking. Sales-trading-research enabled the lucrative equity capital-raising business. Regardless of regulators’ efforts to disconnect banking from analysts’ pay, it has never been more obvious: sell-side research has been funded by investment banking and, without it, firms are going out of business.
In Europe, implementation of Mifid II is forcing investment banks to unbundle research and trading. The US market has only inched toward such a model. Determining a market value for equity research is only the first challenge. Sectors and industries wax and wane through a business cycle. Why should investors pay for early-cyclical research in years when the economy is past the midpoint of its cycle? Then how can early-cyclical analysts make a living?
Bankability of sector/industry coverage determines where broker-dealers invest in research. This force led to overinvestment in technology and healthcare analysts. In the past 12 months, financials, industrials and consumer stocks performed well, while the universe of analysts covering those groups continued to dwindle.
The research-using market has not developed enough incentives to focus independent research analysts on identifying the most/least attractive stocks in the whole stock market. Investors might claim to want that, but their dollars say otherwise.
[The remaining conclusions will form the second and third articles in this series]
Randle Reece is a senior financial analyst and former IRO based in Nashville
