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.

But from a financial system perspective, it would represent a massive duplication of effort. It would also be impossible to manage for the directors and senior executives on the receiving end of investor enquiry, and so would break down. Most importantly, it would be a sure-fire way of ensuring that the information that cost so much to gather would end up pooled by some data gatherers rather than being disseminated across the market. This is why we would have to invent something like sell side research if it did not exist.
For all its weaknesses, sell side research is a massively efficient centralised resource, motivated to gather and to share investment relevant information. Like their buy side clients, sell side analysts are motivated to be right – perhaps even more so given the smaller job market in which they work. Crucially, they are also motivated to be public and loud about their opinions.
Sell side data flows, and, in many instances, is pushed through the financial system. The sell side can therefore have a large effect on market perceptions about particular stocks; in contrast the buy side has much less to gain from sharing data with others and is largely motivated to secrecy. This means that the sell side makes a vital contribution to market efficiency: the collective intelligence of the market, which aggregates the divergent opinions of its constituents into price setting, is at its best in the presence of shared learning about stock price formation that is widely available at low cost. In addition, corporate management is clearly influenced by sell side analysts and their expectations. The five or 10 top sell side analysts in each sector have unrivalled access to senior management.If an issue is on the agenda for these analysts, it will be taken very seriously at board level where directors often use sell side research as a way to check what they are told by management. This is important when sell side research runs counter to current financial valuations, such as Deutsche Bank’s famous study on genetically modified organisms (GMO), which effectively called the demise of Monsanto.
If an issue is not on the sell side agenda – or worse, if top-ranked analysts act as if it is irrelevant – it sends a strong, negative message to management that can lead to misallocation of attention, and thus capital, at all levels. The problem, of course, is that if the sell side generally ignores certain aspects of corporate performance – such as the culture of risk management at investment banks – then the collective intelligence of the market and its allocative efficiency suffers from the related information gap. Equally, investors cannot expect to stock pick their way out of trouble when the problem is a systemic issue that the sell side does not give due recognition. As experiences such as WorldCom, Exxon, dotcom and sub-prime keeps reminding us, these systemic risks can be very costly.
Raj Thamotheram is director of responsible investment at AXA Investment Managers
(1) Members of the UN Principles of Responsible Investment collectively account for $13trn.
(2) ‘The worst market crisis in 60 years’, George Soros, Financial Times, 23 January 2008
This is the first of a two-part article. Next week looks at the future of the Enhanced Analytics Initiative.