Capital markets are the engines of economic growth. Efficient markets channel capital towards productive companies that generate wealth and create jobs over the long term. But in many cases markets do not function as they should. Investors do not have access to the information they need to accurately assess corporate performance and capital is being misallocated as a result.
Sell-side research is part of the problem. By providing investors with analysis and recommendations, the sell side has a significant influence on investment behaviour, and may ultimately determine the success or failure of companies. But sell-side research is overwhelmingly preoccupied with short-term financial metrics rather than long-term value creation, and largely dismissive of environmental, social and governance (ESG) issues. In addition, research is often inappropriately positive in tone, failing to deliver negative assessments of companies where necessary.
Aviva Investors commissioned a survey of 342 sell-side analysts to get a picture of the challenges and pressures that prevent them from producing in-depth research with a long-term focus. The findings are troubling, shedding light on how commercial conflicts of interest and skewed incentive structures interfere with objective appraisals of company performance.
Conflicts of interest
Many sell-side analysts are employed by investment banks, which intermediate between issuers and investors in capital markets. The reports produced by an analyst who works in the research department are often of interest to the investment bankers and investor-relations teams in the same organisation.
This environment breeds conflicts. Our findings show at least 90 per cent of mainstream analysts undertake additional caution when writing on topics sensitive to the bank they work for. And more than a third of mainstream analysts said, for the sake of their careers, they would avoid writing reports that may prove damaging to their employer’s commercial relationships.
Criticisms of a client or potential client of the bank are discouraged – albeit not always explicitly – whereas research that generates trading activity tends to be incentivised. As one sell-side analyst put it: “If your work is good for the bankers, you will get a good bonus.” This encourages short-termism across the wider markets. Trading volumes increase as investors are persuaded to trade unnecessarily and the resulting turnover leads to shorter-term holdings.
Analysts’ short-term focus is partly a function of time constraints. Although they would like to write more in-depth research, mainstream analysts typically spend only 12 per cent of their time researching companies’ prospects beyond a one-year horizon, partly because they need to attend to other tasks such as client marketing and corporate roadshows. Analysts acknowledge these pressures interfere with the quality of their work: as many as 42 per cent of mainstream analysts agree sell-side research has a detrimental short-term focus.
Another problem is that many analysts neglect ESG factors, which typically affect companies over a longer time horizon. Some investment banks have started employing small teams of dedicated ESG analysts, which is a welcome development, but the majority continue to ignore sustainability issues.Only 16 per cent of mainstream analysts consider a company’s environmental impact as relevant to constructing an investment case, despite plentiful evidence that shows ESG matters are material drivers of long-term performance.
Time for change
The flaws in sell-side research are not merely a niche problem for financial-market professionals. Biased, incomplete research may lead to price targets and ratings that do not truly reflect a company’s long-term prospects, leading to a misallocation of capital and impeding the efficient functioning of markets. For capitalism to be sustainable, sustainable companies should be rewarded with a lower cost of capital. Poor quality sell-side research interferes with this mechanism.
To fix this broken system, participants from across the investment chain should come together to effect change. Companies should provide better data on long-term performance and ESG practices to enable analysts to incorporate this information into their reports. We also urge heads of research at investment banks to foster a culture that encourages and incentivises longer-term research, while resisting pressure from other parts of the business.
Regulators also have a role to play. In the UK, the Business Energy Innovation and Skills Select Committee should conduct a review of the practices within sell-side firms that influence analysts’ coverage. And the Financial Conduct Authority should stipulate that research reports must offer an outlook beyond a one-year horizon and demonstrate how material ESG considerations are integrated into analysts’ conclusions and ratings.
The buy side can also do more to push for better standards. The new Markets in Financial Instruments Directive (MiFID II) could be transformational in this regard, giving investors an opportunity to reshape the nature of sell-side research.
Under the new directive, investment firms must pay for research directly, through dedicated accounts, rather than through commission-sharing agreements as was previously the case. If the buy side makes clear it expects, needs and values research that focuses on the long term and incorporates sustainability issues, then practice and habit will change and banks will respond. Analysts will be able to gain a competitive edge by providing the kind of nuanced, objective research investors want.
MiFID II is also expected to encourage a larger pool of research providers independent of investment banks. This should help catalyse more high-quality objective research, provided the buy-side are clear on their expectations and are willing to be more selective when allocating their research budgets.
Post MiFID II, investment banks, asset managers and regulators must work together to ensure sell-side research directs capital towards companies that are generating value over the long term. Better sell-side research will help retune the engines of the economy so that they drive sustainable growth for us all.
Steve Waygood is Chief Responsible Investment Officer at Aviva Investors and Anita Skipper is Senior Analyst, Corporate Governance at Aviva Investors.