Two recent pieces titled “The Future of Equity Research” present differing perspectives on forces shaping equity research. From London comes a white paper examining how potential regulatory changes might alter the research landscape. Meanwhile, a U.S. industry consultant predicts technological transformation of the research process with the advent of big data analytics. Both visions speak to significant change ahead for the consumers and providers of equity research.
Edison Investment Research, a London-based issuer-paid research provider, teamed with Frost Consulting, a consulting firm specializing in commission unbundling, to produce a 60-page white paper on the potential impacts of proposed UK regulation on equity research. UK regulators are proposing to restrict commission payments for corporate access and other primary research, and are considering, along with European regulators, a wider ban on commission payments for research. The paper looks at how research might be impacted by these changes.
Even without the pending regulatory changes, there have already been significant alterations in the research landscape. Frost estimates that there has been a 43% reduction in global commissions for equity research from 2007 to 2012. Frost shows a 29% decline in the US, a 48% decline in Japan/Asia/Emerging Markets and a 58% decline in Europe during the period. At the same time, investment banks have reduced their spending on research (i.e., costs relating to analysts) from over $8 billion to under $5 billion, according to Frost.
Frost Consulting estimates that if asset managers were to absorb the expense that investment banks currently pay for research, it would halve their operating profits. This is not a likely scenario since it assumes regulators would rescind the ability to pay for research with client commissions on a global basis, and that asset managers would replicate investment bank research internally. Nevertheless, it illustrates the stakes involved.
Increased regulatory pressure on the use of client commissions for research, when combined with a more hostile market environment, would lead to tectonic changes in equity research, according to Frost and Edison. The paper posits that investment bank research will move from an unpriced to a priced environment, and banks will become ‘nichier’ by investing in the sectors and geographies which are profitable, while cutting marginally profitable coverage. Consolidation will continue.
Independent research would benefit from the unbundling of bank research, and asset managers would draw from an increasing diversity of research sources. The environment would encourage research aggregators—the paper cites Gerson Lehrman Group as one example. Research distribution would shift from push to pull, fostering more initiatives like RIXML and applications that facilitate selective parsing of research.
As a successful practitioner of the issuer-paid model, Edison Investment Research views prospective regulatory change as positive for its business model, especially when combined with an increased appetite on the part of securities exchanges to facilitate payment for research on under-covered companies.
TABB Group, an industry consulting firm specializing in capital markets, highlights the technological transformation of the research process with the advent of big data analytics. As with the London white paper, TABB notes that shrinking commissions and increased regulatory scrutiny have reduced research resources.
The role of the sell side analysts has shrunk to providing management access and “handicapping quarterly results” while coverage is limited to underwriting clients. It is increasingly rare for the sell side to conduct primary research, and when it does, inputs are limited, undercutting its statistical validity.
At the same time, low cost cloud computing and improved analytic software are making it easier for the buy side to analyze complex data sets. Models are increasingly sophisticated and supersede the traditional spreadsheet models most analysts use. The lowered infrastructure costs have made it more feasible for smaller asset managers to compete with the large hedge funds that have invested in custom-built platforms.
The opportunity exists for research providers to raise their game also. Sell side analysts, as well as buy side analysts, will have to improve their skill sets:
“…to increase their value, analysts will have to do statistical modeling and use analytics tools to gain a deeper understanding of what drivers move markets, sectors or particular stocks. Data discovery and visualization tools will replace spreadsheets for identifying dependencies, patterns and trends, valuation analysis, and investment decision making. Analysts will also need a deeper understanding of client strategies and trading styles in order to tailor their ‘research’ to individual clients.”
The departure for the Edison/Frost paper is regulatory change which is still uncertain. It is not clear, to us at least, how far or how fast UK and European regulators will go with their prospective reforms. Nor is it certain that changes in the UK will necessarily be transmitted to other domiciles. While it is true that commission sharing arrangements (CSAs) spread to the US from the UK with minimal support from US regulators, we strongly doubt that asset managers will forgo the ability to pay for research with client commissions absent decisive regulatory action. And we see no evidence of US regulators taking up the UK cudgel.
Nevertheless, we believe that many of the changes foreseen by the Edison/Frost paper will happen as a result of market pressures, as commissions continue to be under pressure. Regulatory reforms would accelerate a process already largely in place. While unbundling of bank research is unlikely without regulatory intervention (and may not even occur with it), continued consolidation and rationalization is a virtual certainty if current commission trends continue. Independent research and other diverse sources of research would be long-term beneficiaries of increased market rationalization, but they are not immune from the short-term pressures.
TABB is also accurate in its prediction that big data analytics will have a big impact on research. We were talking last week with a mid-sized hedge fund that is hiring programmers to implement in-house analytics for big data. The frustration is that many of the data sources have limited history and do not correlate well with market metrics. This will improve over time, and we will continue to see innovative research providers capitalizing on this trend.