Responsible Investor

Changing the system: why sell side research must improve

The sub-prime crisis has re-opened questions about the quality and independence of sell side research.

It is worryingly ironic that just as 10% of the global financial market declares its commitment to invest responsibly (1) we are experiencing the worst financial crisis in 60 years, which many argue is indicative of an investment and financial market system that does not act as responsibly as it should (2). Collateral damage from the sub-prime debacle continues to cripple financial markets. Its impact is spreading beyond the housing crisis in the US and the shell-shocked global banking sector into growing concerns about whether long-term investors will be able to fund their liabilities if an economic downturn is prolonged.
One of the most troubling aspects of the sub-prime meltdown is that some sell side houses knew about the extra-financial risk. Indeed, they used it in their proprietary trading work (i.e. for their own benefit) and did not publish. Therefore, it is hardly surprising that searching questions are once again being asked of this important element of the investment supply chain. Post Enron, WorldCom and other stock market scandals, reforms sponsored by former New York State governor, Elliot Spitzer, were supposed to have dealt with significant shortcomings on the independence of sell-side research.

Innovest, an independent specialist research organisation, appears to have been the only research agency that called the sub-prime problem in print ahead of the crisis.
The role of the sell side in the formation of stock prices is crucial. Unless brokers pay due attention to the extra financial performance of the companies they research and rate, the ability of fund managers and asset owners to integrate consideration of environmental, social and social (ESG) issues into investment decisions will be unnecessarily delayed. Simultaneously, the signal sent to corporate management in respect of their ESG performance will be concomitantly weaker and the likelihood of undue stock market volatility will persist. In brief, the hopes of mainstreaming responsible investment will be derailed.
In theory the sell side has much to offer the financial system. Imagine a world where investment analysis was fully decentralised and distributed among each and every fund management firm. This would not necessarily be a bad thing in terms of the information discovery that fosters market efficiency: tens, if not hundreds of thousands, of self interested analysts on the trail of the data that would enable them to outperform each other.

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