New York, NY – One of the ideas that Integrity Research Associates has argued over the past few years is that one of the reasons the sell-side research business was broken was that most investment banks didn’t run their research departments as businesses.
However, the pressures facing the sell-side may have caused the tide to turn as more and more investment banks are allocating less of their precious analysts’ time to their less profitable clients.
Consequently, many small and mid sized money managers have begun to find it increasingly difficult in getting the attention of analysts at bulge bracket firms as these analysts have directed more focus on hedge funds.
In fact, some could argue that this trend will be a real problem for mid and smaller asset managers. On the one hand, they won’t be well served by the largest sell-side firms because they just don’t generate enough commissions. On the other hand, they don’t have sufficient assets under management to be able to afford building out their own research departments.
As a result, these firms may have to depend either on regional or boutique investment banks, or they will have to rely on buying research from the more cost competitive alternative research providers. Unfortunately, if none of these options work, it would not be surprising if a number of mid-sized and smaller asset managers look to sell their businesses in order to obtain the economies of scale to be able to compete.
The following article published recently by Yalman Onaran of Bloomberg News discusses this trend in greater detail.
Mutual Funds Get Busy Signal From Analysts Chasing Hedge Funds
By Yalman Onaran
March 5 (Bloomberg) — Steven Roukis, who helps manage $1.7 billion for Matrix Asset Advisors Inc., says he often spent as much as half an hour on the phone with Wall Street analysts five years ago. Today, Matrix handles twice as much money and he’s lucky to get five minutes with anyone.
“You have to call at off-peak hours, like early in the morning,” just to have a word with an analyst, said Roukis, the director of research in New York.
Hundreds of institutional investors like Matrix are getting short shrift because securities firms now order analysts to ignore everyone but the customers who pay the biggest fees. Wall Street collects $33 million a year in stock-trading commissions from the average hedge fund, compared with $16 million from a mutual fund or equivalent investment manager, according to data compiled by Greenwich Associates.
The brokers call it tiering, which typically rewards Stamford, Connecticut-based SAC Capital Advisors LLC, the $12 billion loosely regulated investment pool, open to only high-net- worth individuals and institutions. Such hedge funds are more lucrative for securities firms because their billings include a variety of brokerage services that cater to customized trading and investment strategies unavailable in the mutual funds.
At JPMorgan Chase & Co., the third-largest U.S. bank, Michael Gambardella says he used to have telephone conversations with almost anyone, even non-clients. Now Gambardella, ranked among the top three steel-industry analysts by Institutional Investor magazine for eight of the past 10 years, screens his calls and sometimes spends more than half the day talking to hedge funds.
New Pecking Order
The new pecking order is a necessity, says Stefano Natella, head of global equity research at Credit Suisse Group, Switzerland’s second-largest bank. Since 2003, when Credit Suisse and nine of the biggest securities firms agreed to pay $1.4 billion in fines and banned their analysts from compromising their research to win investment-banking fees, research departments have had to rely on sales and trading for funding.
Analysts can’t send research to favored clients in advance, so they’re writing shorter reports. Natella told his staff to winnow the number of customers to 200 from 600 to ensure the right money managers get enough pampering.
“The only time you can distinguish between clients is analyst time,” Natella said. “Hedge funds want to pick the analysts’ brains for ideas.”
The practice of pandering to hedge funds has become so pervasive that James Wicklund, who spent more than 15 years in equity research, left his job at Charlotte, North Carolina-based Bank of America Corp. three weeks ago.
“Half the people I talked to don’t care what companies do, they’re wondering, `Will I make money if I buy or sell this stock?” said the 53-year-old Wicklund. “The shorter time frame of such investors and their disdain for depth caused research reports to lose most of their value.”
The power shift is depriving many mutual-fund managers of the market intelligence they need to make informed stock picks, and that may hurt their performance, says Ross Miller, a professor of finance at the State University of New York at Albany and author of “Measuring the True Cost of Active Management by Mutual Funds,” a paper scheduled for publication in May in the Journal of Investment Management.
The 10 largest securities firms employ 16 percent fewer analysts than they did in 2001, according to data compiled by Thomson Financial.
Fidelity, Capital Group
To be sure, mutual-fund managers at industry giants Fidelity Investments in Boston and Los Angeles-based Capital Research & Management Co. still get calls. It’s the smaller firms that are losing their traditional access to analysts.
“Smaller mutual-fund managers, who are strongly dependent on sell-side research, will get burned,” said Miller, whose consulting firm, Miller Risk Advisors in Niskayuna, New York, has worked for companies including Barclays Plc, the third-largest U.K. bank, and Bank of America, the No. 2 U.S. bank after Citigroup Inc. “They’ll either get gobbled up, go out of business or become hedge funds.”
Five years of surveys by Greenwich Associates show declining interest in the analysis popular during the Internet boom of the 1990s, when research reports frequently stretched into the hundreds of pages. Institutional investors say written research is half as valuable as it was in 2002, according to the Greenwich, Connecticut-based consulting firm, whose surveys are used by money managers to monitor trends in the brokerage industry.
As the number of hedge funds doubled to more than 9,000, demand surged for the kinds of short-term strategies that fuel returns at managers like SAC Capital. Hedge funds, which now account for at least a third of the $10.8 billion a year in equity-trading commissions paid by U.S. institutional investors, also pay brokers other fees such as interest for borrowing stocks and clearing trades.
“There’s more interest in idea-generating analysts,” said Tom Larsen, head of research at Harding Loevner Management LP, which runs $5 billion of assets in Somerville, New Jersey. “Company knowledge combined with actionable ideas might replace publishing research on paper all together.”
The result is that research may be even more of an insider’s game than it was during the Internet bubble, said Dan Reingold, who covered the telecommunications industry in New York for Morgan Stanley, Merrill Lynch & Co. and Credit Suisse in the 1990s and wrote “Confessions of a Wall Street Analyst” (Collins, 2006).
Back then, Citigroup’s Jack Grubman, Reingold’s archrival, and Merrill’s Henry Blodget put ratings on stocks to satisfy investment bankers and disparaged the same companies in private. Today, analysts make themselves indispensable by gleaning trading tips for select investors or arranging closed-door briefings with company managers.
“The question has become: Does the analyst give a heads-up to his best clients while he’s trying to serve them better?” said Reingold. “Or whether the actual opinion of the analyst, the recommendation, is influenced by the client.”
The temptation to profit from hedge funds was so strong for Mitchel Guttenberg, an executive director in UBS AG’s equity- research department, that he sold advance notice of analyst ratings to traders, according to a lawsuit brought by federal prosecutors last week. The U.S. attorney’s office in Manhattan filed criminal charges against 13 people, marking one of the biggest insider-trading cases since the 1980s.
Matrix’s Roukis says he has to do more of his own spadework now that it’s hard to get analysts on the phone. He depends on the Internet.
“Ten years ago, this business was all telephone and fax, which made communication tough,” said the 39-year-old Roukis. “There are more opportunities to get at primary data today than there have ever been.”
Marshall Wace LLP, the London-based money manager that raised $2 billion in December in the biggest initial public offering for a hedge fund, forces the brokers who want to win its business to key trading suggestions into a dedicated Web page. Marshall Wace then uses software to evaluate the ideas and allocates trading commissions accordingly. The software won’t accept written reports.
New York-based Citigroup, Credit Suisse, Merrill and Germany’s Dresdner Bank AG founded Trade Idea Monitor, a system that similarly aggregates trading proposals for investors. New York-based Merrill and rival Lehman Brothers Holdings Inc., along with Zurich-based UBS, are among the securities firms that assigned analysts to trading desks, where they discuss strategies with clients and no longer publish research.
“The requirement for executable ideas has grown,” said Margaret Cannella, the New York-based head of U.S. corporate research at JPMorgan. “That has made written research shorter, more insightful. Analysts spend more time with clients as well as the trading desk, providing actionable ideas.”
Instead of just providing recommendations on what stocks to buy and sell, analysts also help structure trades and advise investors on what derivatives to consider. Candace Browning, head of research at Merrill, the world’s largest brokerage, says she tells her analysts that client contact is four times more valuable than written reports.
Until 2003, when then-New York Attorney General Eliot Spitzer drove 10 securities firms and commercial banks into the $1.4 billion settlement by revealing scandalous e-mails, Wall Street research departments received about a third of their revenue from investment banking.
Use the Phone
Natella, who joined Zurich-based Credit Suisse as an analyst in 1989, says companies often gave out underwriting assignments on the basis of written reports. “Sell” ratings made up only 2 percent of all stock recommendations in 2000.
Brokerage firms now employ lawyers in the compliance department to review all research before it gets distributed to clients. At Merrill, Browning, says she tells her analysts to write less, though the typical report “hasn’t shrunk as much I’d like it to.”
Chris Jarvis, who worked as an energy analyst at Merrill until last August, says he was told to spend more time pitching investment ideas to clients on the phone instead of putting them in reports or e-mails. Jarvis now runs his own hedge fund.
“The vast majority of written reports provide very little added value,” said David Roberts, who left Northern Trust Value Investors in 2004 to establish Harvest Investment Advisors in Tallahassee, Florida. “That’s why meeting with and talking to analysts is so valuable because you can focus on that marginal content.”
To contact the reporter on this story: Yalman Onaran in New York.
Last Updated: March 4, 2007 21:29 EST