I started out on this series thinking I would ask where investors – private and institutional – will go for good research, given that regulation – particularly Mifid II due to come into force next year – is said to be causing brokers to lay off their analysts. This raises the question: What is good research anyway?
But on reading through the excellent description of the increasingly complex regulation minefield, by ‘paid-for’ research provider Edison Investment Research (“The Future of Equity Research”) and how regulation during the last twenty years has affected its provision and will do even more so, one is struck by how the regulators – starting in the UK with the FSA in 2001 – seem not only to ignore the needs of private investors, but also want to micro-manage even the way professional analysts and fund managers actually do their job.
At base, investment regulation has developed due to the regulators believing that too much cost was being passed on to fund managers’ clients – a large reason for which was the freedoms delivered by Big Bang in the 1980s, with a resulting proliferation of the ‘sell-side’, expensive and often redundant research that banks and brokers were able to charge for via commissions. So the forthcoming Mifid II strictures will extend the rules to ensure that fund managers account transparently to their clients – in frightening detail – for the cost and ‘benefit’ of the research they rely on to manage their funds.
This is fine as a simplistic aspiration. But the way the lawyers have drawn up their various ‘Conduct of Business’ rules so far displays a worrying ignorance of the process of research and even of fund management itself. Like the strictures of the FSA/FCA, these look like producing even more unintended consequences for the poor old private investor similar, to the effective denial of broker research because the lawyers don’t think private investors are capable of understanding it!
An illustration of the gap between exhortation and reality can be seen in new rules that expect fund managers to separate out in their charges research that isn’t ‘value generating’.
A key COB rule says in effect that an investment manager can’t use dealing commissions to reward research unless it:
(a) is capable of adding value to the investment or trading decisions by providing new insights that inform the investment manager when making such decisions about its customers’ portfolios;
(b) whatever form its output takes, represents original thought, in the critical and careful consideration and assessment of new and existing facts, and does not merely repeat or repackage what has been presented before;
(c) has intellectual rigour and does not merely state what is commonplace or self-evident; and
(d) involves analysis or manipulation of data to reach meaningful conclusions.
Any experienced analyst or fund manager would tell them that ‘value generating anomalies’ don’t grow on trees. To spot one that comes along perhaps only rarely needs a long slog following in detail the progress and investor perceptions attached to a particular share and its industry (denigrated as ‘maintenance’ research). So Mifid II will expect a poor old analyst to earn nothing for his lengthy run-of-the-mill plodding (which a fund manager will value in order to ensure the ship is still steady) and only to earn something if he’s lucky to spot when it might be about to capsize or when the trade wind is about to strengthen.
The same ignorance and hand-holding underlay the strictures of the FSA before Mifid, which expected brokers to make an equal number of sell recommendations as buys – as if that is the way their profession works. With the positive inflow to a typical fund normal during healthy stockmarket phases, managers rarely completely sell a holding; they just don’t buy more, and instead divert incoming flows to new ideas. So it never was worth anyone’s while researching sell opportunities, but only to look for the buys.
What, in effect, Mifid wants to do now is to pretend to the ultimate investor that he needn’t pay to ensure that his investment remains sound. This is just one example of the nonsense of the complex regime the Regulators are trying to impose, which even includes tying down the ‘value’ of research into micro sectors, fund management clients, and market sectors.
If you believe fund management is an art as much as a science (which you would if you didn’t believe in the nonsensical ‘efficient market’ theory) then you would realise that trying to quantify the ‘value’ to a fund manager of each of the innumerable sources of information and opinion that he relies on when making a judgement is as feasible as trying to sweep up a spill of mercury on your shaggy carpet.
The cack-handed way in which the rules have been drawn is shown by one of Edison’s findings (whether anecdotal or not, they don’t say) that some fund managers were left uncertain whether they would have to agree with and follow research conclusions in their actual investment decision. The FCA advised that this would not be the case, noting that ‘sometimes research which offers a contradictory view can often still be of value’.
“Gee thanks Mr Regulator! So I can decide for myself after all whether a research note is good or bad? Hold on though. Why don’t I just hand all my fund management over to you?”
The effect of all the regulation so far – exacerbated by the 2008 market crash – has already been an estimated halving of analyst numbers and the withdrawal from the equities market of many private investor brokers. And while much of their research – ‘sell-side’ as it was – might have been of questionable value, the result is that there are now large swathes of equities not researched at all. Hence the expansion of firms like Edison who charge companies to pass on research to investment managers (as also to private investors via their web site). Given that it is their policies that have made such ‘paid for’ services necessary, the regulators have given them a green light and overlooked that they might not be absolutely objective.
So serious is the trend for less and less research coverage that some stock exchanges are having to encourage ‘commissioned’ research themselves, though it seems unlikely they could make much dent in the 55% of all listed companies world-wide that it is estimated are now not researched at all.
The new Mifid rules are expected to perpetuate this trend and instead to encourage more ‘buy-side’ research within investment management firms which, by definition, will be even less accessible to the poor old private investor – left in the cold while fund managers gain even more advantage over him.
The extraordinary thing (although perhaps not to the cynical) in all this meddling and hand-holding is that the side-effects – the resulting diversion of private investors to other opinion sources whose objectivity and quality are not regulated at all – is completely ignored.
This is happening because even the regulators can’t stop free comment (at least, not yet) by a free press, which can publish or republish what it likes as share tips – as also can independent share newsletters. These, of course, will stand or fall by their track records (a subject in itself – see later) but are not subject to any sort of quality control – just like the proliferating public relations platforms and share bulletin boards that I have watched with appalled fascination as they draw in inexperienced private investors with often dubious and non-objective ‘puffs’. These of course are not subject to any sort of performance check.
So it is that, as usual, regulators attempting to micro manage almost always cause collateral damage. Which to acknowledge would mean cutting back on their own cosy careers. Will our masters ever learn?
Amidst the damage the question of what constitutes good research is ignored. Almost by definition, and if you believe in the ‘efficient market’ theory, most research recommendations won’t be ‘value generating’ because they will depend on information already in the public domain – so the Regulators might as well say that no research is required at all. But, as Tim Price says, and as was the case twenty years ago when I was engaged in a debate in the pages of the FT and elsewhere, the efficient market theory always was nonsense but was doggedly held by some pundits (who also put forward the ‘random walk’ theory to pretend that out- or under-performance didn’t exist except as a statistical freak). But they were almost all actuaries – concerned with the overall stock market as it fitted into the economy, with seemingly none having researched an individual company.
In a future article I’ll talk about performance tables and how to properly assess share tipsters and fund managers, as also how to spot the sleights of hand and marketing and statistical tricks that the regulators in their great wisdom naturally haven’t spotted, let alone done anything about.