A majority of U.S. institutional investors say the strengthening of existing Chinese Walls is the best means for reforming sell-side equity research, but fewer think it will resolve conflicts of interest and fewer still that it will improve the quality of research. Or so says a recent survey of buy-side opinion by Greenwich Associates.
Just over half of senior management (i.e. directors of research and chief investment officers) and equity analysts at the 51 U.S. institutions Greenwich Associates surveyed (a majority of which have $20 billion or more in total assets) told the consultancy that tougher enforcement of Chinese walls is the best model for investors and the industry as a whole. A third want to see equity research split off from investment banks as a completely separate business, while a small group prefer a middle course where independent research for retail investors would be funded by investment banks and “ring-fenced” research would be maintained for institutional investors.
But only a third of these institutional professionals believe tougher-enforced Chinese walls can be effective, or that sell-side research will be less biased as a result of any restructuring that takes place.
“It looks like change is not only not going to please, it’s not going to please anyone,” Greenwich Associates consultant John Webster says.
The fact that most institutional professionals support Chinese walls, the current control in place, even as many went on to say the system is not effective in preventing conflicts from arising, nor will they be if Chinese walls are strengthened, may seem to run against the current tide for reform. However, this is consistent with the thinking institutional investors have demonstrated in Greenwich Associates studies over the years. Institutional investors tend not only to be aware of the conflicts of interest that exist on Wall Street, but expect them.
What was unexpected in the results of our survey was that only half would support strengthening the system in place, and of the rest, that most would support a far more radical reform of completely splitting off equity research from investment banks.
“What we have here is a very split group, black and white with little middle ground,” Marketing Manager Melissa De Vries says. “Only a few saw the solution regulators have proposed as an attractive halfway step, despite the attention that idea is getting in the press. This illustrates a schism that can be tracked throughout our survey.”
Large majorities of those surveyed say they expect investment banking will cover less of the cost of sell-side research as a result of reform (64%) and that less sell-side research will be made available (68%) when restructuring occurs. Half agreed equity research will have to be subsidized by other lines of investment banks’ business. Nearly all (95%) say sell-side equity analysts will be paid less for their work than they are now.
Responses were more mixed when institutional investors were asked if they expect to pay higher commissions for equity research. Directors of research and chief investment officers were firmer on this point than analysts, with 56% of the senior management saying yes.
“Despite these mixed expectations, one sees a pattern where institutions expect fewer dollars to go toward broker research,” Melissa De Vries notes. “This has clear implications. Good research requires smart people, and when those people are either let go or not properly compensated because of budgetary cuts, the quality of research suffers.”
The question of the impact of restructuring on research quality was the survey’s most surprising finding. It stands to reason that reform will cost something, but shouldn’t there be some expectation for improvement? Fully 66% of investors responding indicate that restructuring will not sufficiently improve the independence and quality of sell-side research.
While there is much uncertainty, both senior management and analysts do not expect sell-side research to be any less biased as a result of investment banks restructuring equity research. When asked what they expect, 43% of the combined group say no, with senior management more negative than analysts. A quarter more were undecided, leaving only 32% of investors expecting sell-side research to be less biased as a result of reform.
“That is a fairly significant number saying that whatever they do to restructure equity research, there are still going to be problems,” John Webster notes.
The clear majority (64%) of senior management at buy-side institutions plan to maintain both their current in-house equity research staffing levels and their existing reliance on broker research. Just a fifth say they will increase in-house staff and rely less on the sell-side for their research. No plans were mentioned by senior management to reduce in-house equity research staffing.
While most institutional investors (62%) say they are not willing to pay higher commission rates for sell-side equity research, the vast majority of the 16% that said they are willing to pay more are from the largest institutions Greenwich Associates surveyed, the over-$20-billion-in-assets group. These institutions are the most prized brokerage clients, and suggest sell-side research may find some incremental revenue.
“Basically, you’re damned if you do and damned if you don’t,” John Webster says. “Sell-side analysts may find themselves in a situation where this is a less-than-desirable side of the fence to be on from a compensatory point of view. And while some structural issues may be tackled, the field will be less attractive to work in and more of a loss leader than it is already. Without cross-subsidization, the economics are going to be under severe pressure.”
From November 13-22, 2002, Greenwich Associates conducted an online survey with 25 senior managers (including chief investment officers and directors of research) and 38 in-house equity analysts at 51 U.S. institutions about their views on sell-side equity research reform. Of these institutions, 28 have over $20 billion in assets, six have between $10-20 billion in assets, nine have between $5-10 billion in assets, and eight have less than $5 billion in assets.