For three years now, the Enhanced Analytics Initiative (EAI) – which sees buy side firms and asset owners united in explicitly rewarding sell side research organisations that produce good quality research on extra financial factors such as ESG issues – has worked to reduce the unnecessary volatility in stock market returns that comes from the presence of critical information gaps in respect of long-term corporate health and performance. EAI’s 27 institutional members together hold assets of over $3trn (€1.9trn), giving them considerable market clout. It should come as no surprise, however, that there is much yet to be done. For example, several brokers with whom EAI members have strong commercial relationships continue to produce stand-alone reports. This means that even their most important ESG conclusions are not routinely reflected in the mainstream notes that shape consensus numbers and opinion.
Why is change so difficult and yet so important?As William Donaldson, former analyst and SEC chairman has said: “To state an obvious, but often overlooked fact – quarterly earnings do not reflect companies’ long-term viability. Identifying the factors that will drive long-term growth – such as personnel, strategy, financial strength and flexibility, internal corporate governance, innovation and customer service – may be more difficult to quantify, but they offer a more accurate and more complete portrait of a company’s future.” (1) Prior to EAI’s formation, just a handful of sell side houses allocated resources to filling this information gap in securities research. Since, the number of research houses covering extra-financial factors has increased significantly, both in quantity, quality and geography. Relevant research from analysts in Australia and Asia is now increasingly common. Most sell side staff are clear that EAI has been a critical factor – if not the defining factor – in getting the necessary management support and extra financial resources for this research. The result has been an
increasing presence of sell side houses at almost all responsible investing events today. This is indicative of their credibility with asset owners as much as fund managers. Good sell side commentary on extra-financial performance is giving mainstream buy side and asset owners the confidence to factor relevant ESG issues into their investment decisions.
Worryingly though, some sell side houses have regressed and lost specialist staff. Despite repeated requests for better corporate governance coverage, progress has been slow. The one house that had such expertise has recently lost it. This raises questions as to whether sell side firms are able to address the conflicts of interests that hinder such ‘sensitive’ commentary, or whether EAI and others will have to focus on independent brokers. In addition, coverage of the North American market remains very weak. Some houses still struggle to secure the intellectual engagement of their US-based analysts: one of the reasons perhaps for why the sub-prime contagion started there. ESG coverage of sectors in North America bears little relevance to market weightings. In three years, EAI members have seen approximately 50 automobile but only 25 banking sector reports they considered appropriate for evaluation. Finally, credit rating agencies, which were not included in the EAI process, have made very little progress on extra-financial risk assessment. Furthermore, some buy side professionals are yet to be convinced about the merits of the EAI. They argue that they do not depend on sell side research and are therefore reluctant to reward it explicitly. The reality, however, is that few buy side firms have unbundled and even fewer have stopped payingfor research completely.
I have yet to hear of a firm that never meets sell side analysts. Others assert that they already see and reward good ESG research. It is difficult to reconcile the average quality of sell-side research on ESG matters with the number of managers who say they are rewarding it. What is certainly true is that changing allocations to sell side research is an intensely political issue, so it is not surprising that other reasons are used to explain an understandable resistance to change.
It is also true that many portfolio managers ignore the output from a given sell side valuation model when they come to making stock decisions. Although such valuation models can be an important resource for some buy side firms, what many buy side analysts want is better access to the raw data that the sell side has gathered. They also want better access to the sell side analysts for the bespoke and deeper data dives they can facilitate, for their thinking about the variables in the valuation equation and for easier access to key corporate executives. Since this information exchange promotes the market efficiency that all active investors rely on to ensure that the mispriced stocks they invest in gravitate towards their proper valuations, access to the right sell side research is worth rewarding. If extra-financials have been forgotten from that calculation of fair value, the buy side will generally transmit that failure.
As with any successful growing project, especially where the context itself is fast moving, there also comes a time to review it. The initial design of EAI focused on a specific percentage of brokerage commissions to be allocated to a small list of extra financial ‘winners’.
It served its purpose well and created momentum for change. The biggest challenge now is to get relevant extra-financial analysis direct to mainstream analysts. Given the limited time they have for reading reports and talking with sell side counterparts, the solution is to genuinely embed analysis of material ESG issues into the normal research process. It is also essential to ensure that those sell side houses that move in this direction are rewarded for so doing in a way that their analysts and senior management can value and track. How to achieve this will require creative strategic thinking by the current members of EAI. Now is also a good opportunity though for asset owners and fund managers who have – for whatever reason – not yet joined EAI, and for sell side and independent research houses, to give their input.(2)
EAI gives long-term investors who care about the integration of extra-financial factors into the research process a practical way to put their words into effect. This is particularly relevant to the members of the United Nations Principles of Responsible Investment (PRI), the majority of whom are not yet members of EAI but have committed to encourage integration of ESG analysis and to report on it. Once PRI’s $13trn – which accounts for $1 out of every $10 in the financial system today – starts to speak on this issue, we will be at, or very near, the tipping point where stock market valuations come to reflect extra-financial performance, and where corporate management embraces a holistic perspective of corporate performance.
While the focus for asset owners and fund managers is rightly on more accurate pricing of risk and reward, we should not ignore the wider benefits of this change.As respected US commentator William Greider notes: “A transformation of Wall Street’s core values is not only possible, but eventually likely to occur…though this will take many years (maybe decades) to achieve, it would represent a generational accomplishment more enduring and meaningful than any of the current preoccupations of politics, since the very foundations of public life would be altered.” (3)
“The solution is to genuinely embed analysis of material ESG issues into the normal research process.”
Why is someone who has been so critical of Wall Street so optimistic? “Within the monolith of finance some adventurous players are always experimenting with new methods and theories, trying to take profit from what the larger herd doesn’t yet see or understand. When renegades succeed, the system typically steals their ideas and tries to emulate their approach,” says Greider.
Focused on one small but critically important aspect of this wider agenda – namely the need for more rounded sell side research – and with the impact of sub-prime on our clients fresh in our minds, EAI members are committed to making sure this transformation is a matter of years rather than decades. We would welcome the support of peers in speeding this process along.
Raj Thamotheram is director of responsible investment at AXA Investment Managers
(1) William H Donaldson: Remarks to the CFA Institute Annual Conference Philadelphia Pennsylvania, 2005
(2) Suggestions should be sent to Peter Scales, chairman, EAI: firstname.lastname@example.org
(3) ‘Soul of Capitalism: opening paths to a moral economy’, William Greider, Simon and Schuster, 2004