One of the drawbacks of the convoluted payment process for investment research is the difficulty that research providers have in determining what their clients truly value. While there is ample evidence that an increasing share of the equity commissions paid by institutional investors goes toward research (at least while the overall pool of commissions shrinks), the commissions paid are at the discretion of the investor, and are generally paid after research services have been rendered, in bulk, with minimal explanation. For these reasons, the surveys conducted by Institutional Investor magazine (or II) have more sway than they would if the payment process were not so opaque.
The centerpiece of the II surveys are the rankings of analysts, and considerable effort is expended by II, the buy side and the sell side in conducting the surveys. II publishes the key factors that investors say are a key consideration in determining their votes. Let’s examine these factors and how these factors have changed over time.
The II rankings have consistently highlighted a few attributes over the last decade: industry knowledge has been ranked as the most important quality since 2000. Special services such as company visits and conferences and written reports have also been relatively highly ranked since 2000. Integrity and accessibility are now ranked highly (#2 and #3 from 2005 to the present) but absent a decade ago, although ‘Servicing’ (ranked #6 in 2000) would include accessibility.
Instead, II found in 2000 that investors valued market making and ‘primary market services’, which typically includes allocations of IPOs and other securities. You would expect market making to be more associated with execution than research, but in 2000 there was less precision in how commissions were allocated and the reasons why. Not that things are completely transparent even today. It is often the head trader who ultimately manages the commission allocations, and, depending on the buy side organization, the input from the research side of the investor can sometimes get overruled or ignored.
Primary market services is undoubtedly an important factor in commission allocations, as we have heard repeatedly as the IPO markets began heating up in the last year. However, it is not clear whether payment for IPO allocations is a legitimate research expenditure, so it is politic for II to have dropped this from the list of factors.
New factors that have been added recently include ‘local market knowledge/country knowledge’, reflecting the increasing importance of non-US equities, as well as idea generation and research delivery.
Since the II rankings center on analysts, the values expressed by investors in the survey focus on what makes a successful analyst. However, this may not fully correspond to what investors ultimately value in research. Analysts, while a key factor in research, are not the only factor. To see this more clearly, let’s compare the II rankings to the factors that determine commission allocations, as reported by Greenwich Associates. Greenwich surveys between 130 and 140 buy side institutions to determine the size and nature of their equity commission allocations. The Greenwich survey is a useful benchmark because it provides insights on what investors actually pay for.
Consistent with the II rankings, analysts are the most valuable component of commission allocations, according to the Greenwich survey. For the period ending early in the first quarter of 2011 (essentially the year 2010), the institutions surveyed by Greenwich allocated 24% of the commissions used to pay for research to ‘Analyst service’. However, as we have noted before, the value of the analysts has been declining over the last few years, as the value of corporate access has been increasing. In the II survey, management access (defined as one on one access) declined in importance, but ‘Special services’ which include company visits and conferences is consistently highly rated in the II survey.
Greenwich consistently shows that sales service is an important component of commission allocation, while this has faded in importance in the II rankings survey. In 2000, ‘Quality of sales force’ was ranked #8 in the II survey, but then disappeared subsequently. Similarly, stock selection was ranked by II in 2000, but not after, while Greenwich reports that ‘Thematic investment ideas or specific stock recommendations’ remains an important factor in commission allocations.
The contradictions between the II and Greenwich surveys are symptomatic of the difficulties in interpreting the arcane and opaque commission allocation process by which the majority of research gets funded. While there is undoubtedly more transparency in research allocations over the last decade, as commission sharing arrangements have become more prevalent, there remains considerable room for improvement.