On March 23, Candace Browning, the head of global securities research at Merrill Lynch & Co., sent a letter to the firm’s institutional brokerage clients notifying them of big changes coming: Research reports would no longer be available to anyone other than paying clients, and licensing agreements were to be tightened to ensure that Merrill’s work would not be redistributed without the firm’s getting paid for it. The measures, Browning wrote, were designed to protect Merrill’s work from being “Napsterized,” or spread around the Web to a wide array of people who don’t pay for it. Late last month the firm followed by restricting media access to many of the reports generated by its analysts.
Merrill’s move underscores a dramatic turnabout on Wall Street. Not long ago brokerage houses cultivated the widest possible audience for their research reports and the highest possible profiles for the people who wrote them. In the late 1990s some analysts had their own press agents; firms installed cameras on their trading floors so that researchers could spout their wisdom on cable business channels like CNBC. It was all part of an effort to curry favor with a group then seen as the most powerful emerging force in high finance: average Joes.
It only made sense. Millions of people of modest means were flocking to the bull market, eager to make a killing in stocks. Online brokerages like Ameritrade — remember the too-cool TV pitchman “Stuart” hawking those $8 trades? — threatened the established Wall Street order, and “democratization of finance” became a ubiquitous catchphrase. Even when the workaday crowds weren’t paying customers, big firms like Merrill had an incentive to spread their research far and wide — doing so fed the public’s appetite for a seemingly endless stream of hot IPOs, which carried lucrative underwriting fees for Wall Street. It didn’t hurt, either, that companies tended to select underwriters based on which firms were seen as having the most influential analysts.
When the ’90s bubble burst, of course, regulators took aim at malign industry practices by promulgating a host of reforms, from the Securities and Exchange Commission’s Regulation Fair Disclosure, implemented in October 2000, to rules that accompanied the $1.5 billion settlement in 2003 between big brokerages and a host of authorities, led by then–New York State Attorney General Eliot Spitzer.
The goal was to make Wall Street safe once again for the little guy. The result has been far different: Big brokerage houses have turned their backs on small investors. That, to a cynic, might be a good thing. But it certainly isn’t what the regulators intended.
Wall Street’s about-face is, in part, simple business logic. Research, divorced from investment banking, has been pared dramatically instead of promoted. Firms are slashing budgets, cutting corners, discouraging analysts from making public statements and focusing their research efforts increasingly on the biggest, most sophisticated and most profitable clients.
“We went through a period in the ’90s when the philosophy was to get the name out there and really brand the analysts,” says Merrill’s Browning. “People really weren’t doing a thorough business analysis of whether it made sense to distribute the research to certain entities.”
Today’s retrenchment may be a return to research’s roots. Modern sell-side analysis began in the 1960s with a handful of firms taking deep dives into often little-known companies, and frequently emerging with truly unique investment ideas for the institutions that were managing a growing portion of U.S. equity assets. By the 1980s that cottage industry exploded, becoming a way for firms to market themselves — not just to brokerage customers, but also to investment banking clients. Since regulators exposed the conflicts inherent in that arrangement and passed corrective rules, sell-side research has spent the past several years struggling to redefine its identity.
Hedge funds, which funnel billions in commissions and other fees to securities firms annually, are the biggest beneficiaries of this shift. These lightly regulated, private pools of capital invest primarily on behalf of the ultrawealthy and such institutions as college endowments and charitable foundations. They often employ rapid-fire trading styles and have far different research demands than small individual investors or even traditional institutions like mutual funds.
“The large firms have skinnied down their research,” says Horacio Valeiras, chief investment officer at Nicholas-Applegate Capital Management, a $15 billion-in-assets mutual fund complex in San Diego. “They generally go to the hedge funds first, and there are so many hedge funds now that all want access to information first.”
At the same time, firms that once competed fiercely with the likes of Charles Schwab and E*Trade for everyday-investor clients have shifted their priorities and are now seeking to do business with only the wealthiest and most sophisticated individual customers. Since 2005, Merrill and Morgan Stanley have directed clients with less than $100,000 to invest away from personal brokers to call centers, where they are serviced from afar by teams of less-experienced personnel. Even accounts of up to $250,000 can be relegated to this second-class status if firms deem them uncomplicated and inactive.
“The high-net-worth divisions of the wire houses are looking to reel in the clients that have $5 million to $10 million in investable assets,” says Mark Elzweig, president of Mark Elzweig Co., a New York executive search firm that specializes in retail brokers and money management professionals. “They’re not really going after the small investor anymore.”
Wall Street is not only shunning the masses directly; it’s also showering far less attention on the institutions that represent them in the market. Once valued clients of major brokerage houses, many traditional money management firms that operate mutual funds or oversee the pension assets of millions of police officers, firefighters, bus drivers, teachers and factory workers are finding themselves knocked down a step in the new broker-client hierarchy. Unable to use banking to fund research, brokerages have been forced to rely almost solely on trading commissions to pay analysts’ salaries and other costs. As a result, they are providing a higher level of service to the biggest commission generators — generally hedge funds and the top mutual fund houses — and cutting back on what they give everyone else. If research was once a quasipublic commodity, today it is unquestionably a private good delivered only to those willing to pay market prices.
“The larger firms are being far more selective about who has access to what,” says Daniel McClure, portfolio manager and director of research at Investors Group, which, with $48 billion in assets, is the biggest mutual fund family in Canada. “They’re culling accounts, deciding who’s on the ‘A’ list, the ‘B’ list and the ‘C’ list and providing service commensurate with the level of commissions clients generate.”
McClure’s firm is big enough that it usually makes the “A” list. But hundreds of other money managers with tens of billions in retail assets have been shunted aside by Wall Street. These firms are adapting by boosting their internal research ranks, as well as by relying more on independent research and regional brokerages. Even big firms that continue to get attention from the sell side are making similar moves, thanks to the regulations that have decreased the amount and, they think, the quality of research coming out of bulge-bracket brokerage firms.
For the masses of average investors whose first exposure to the stock market came during the past decade, this transformation is having dramatic and far-reaching consequences. If they don’t have hefty enough portfolios to attract a big brokerage house’s attention, they no longer have access to that firm’s research. Even retail clients who make the cut only receive access to printed reports on a firm’s Web site. Securities firms are deemphasizing these written reports while ramping up higher-touch service, such as arranging meetings with CEOs and CFOs of the companies they cover for hedge funds and other more lucrative clients. Small individual investors don’t get that white-glove treatment, and have few options when it comes to research and advice. Even online brokerages, having weathered the bubble’s bursting by consolidating and diversifying their business lines, today court clients who trade a lot or have big enough accounts to generate significant asset-based annual management fees.
To be sure, hedge funds have taken in billions from pension funds whose beneficiaries are everyday investors. And the very biggest mutual fund houses, such as Capital Group and Fidelity Investments, generate enough commissions to warrant top-shelf treatment from Wall Street. But most institutional investors allocate only a tiny fraction of their assets to hedge funds. A State Street Corp. survey of public and private pension funds, as well as college endowments and philanthropic foundations, shows that 55 percent of these institutions allocate less than 10 percent of their portfolios to the sector. And individuals can’t invest directly in hedge funds unless they’re far wealthier than the small-time investors who Spitzer, now governor of New York, and the SEC purported to be protecting with their reforms: Current regulations keep anyone with a net worth less than $1 million out of hedge world. Equity mutual funds, however, manage some $6 trillion of Main Street America’s savings, according to the Investment Company Institute. About 71 percent of that sum is in the hands of the 25 biggest managers. The rest lies in funds that are being snubbed by Wall Street.
There has been plenty of blather over the past decade about the democratization of finance, the “Ownership Society” envisioned by President George W. Bush and the power of the self-directed retail investor to influence Wall Street and corporate America through everything from online brokerage accounts to 401(k)s and Dutch-auction IPOs like Google’s in 2004. But the small investor’s standing in the markets has hardly ever been more precarious.
Six years after Spitzer’s investigation began, research is undergoing the most profound transformation since the deregulation of commission rates in 1975, a move that loosed brutal competition on the industry and triggered a massive consolidation wave.
The Spitzer settlement, in which 12 firms agreed to adopt changes in business practices to settle research-related securities fraud charges, grew from revelations that analysts knowingly touted lousy companies to help their firms’ banking divisions. Consequently, the agreement barred analysts from working with investment bankers on deals and prohibited firms from paying analysts based on their contribution to banking revenues, among other strictures. The SEC followed with Regulation Analyst Certification, which requires researchers to attest that their written opinions are consistent with the conclusions drawn from their research. Earlier, Reg FD prohibited companies from selectively disclosing information to favored analysts or investors; any material information was to be released to the whole market simultaneously, theoretically eliminating any information advantage that accrued to big, well-connected professionals at the little guy’s expense.
The new rules have forced big brokerage houses to do more with less. Investment banks still feel the need to cover a wide array of companies because clients still hire underwriters based in part on research coverage. But the settlement prohibits firms from linking the two formally, making research departments economically dependent on a shrinking revenue stream: brokerage commissions. Institutional equity commissions in the U.S. fell from $13.4 billion in 2002 to $10.8 billion last year, according to consulting firm Greenwich Associates. Another consulting firm, TABB Group, projects a further $1.7 billion decline in 2007. Commissions are falling as institutions take greater advantage of efficient electronic trading venues that charge lower rates than traditional Wall Street desks, a trend being fueled by scrutiny of commission spending by fund boards and clients.
Firms have responded by slashing analyst rosters and reducing the compensation of those who remain. Many, such as JPMorgan Chase & Co. and Morgan Stanley, have combined equity and debt research — a head-count reduction that such firms say positions them to accommodate investors who are increasingly playing in both markets. Facing lower pay and less prominence, seasoned analysts have left in droves, many for the greater financial rewards of hedge funds and their own firms’ proprietary trading desks. In the past two years, several well-known researchers, including UBS airlines expert Samuel Buttrick and Morgan Stanley convertible bond specialist Anand Iyer, both of whom were perennially cited as tops in their sectors by voters in this magazine’s annual All-America Research TeamTM survey, have shifted to prop trading. Others are becoming investment bankers; since February, media and cable researcher Aryeh Bourkoff switched from research to banking at UBS; semiconductors analyst Mark Edelstone left Morgan Stanley to become a banker at JPMorgan; and UBS hired Credit Suisse researcher William Drewry to advise publishing companies. Those who remain in research departments are generally younger, less experienced and covering a wider universe of stocks with fewer junior analysts and support staff to assist them. In the aftermath of Regulation FD, they’re also less able to provide clients with prized access to company executives.
To be sure, some firms are investing in research but only in fast-growing markets such as Brazil and Asia, particularly China. “In the U.S. it’s very much about stretching your resources to the max,” says one bulge-bracket research chief. “Budgets are stagnant to shrinking. You have to scrimp and save here so you can make investments in other parts of the world.”
Wall Street is making the new economics of research work by catering to the rapidly expanding ranks of hedge funds at the expense of institutions that generate smaller piles of commission dollars. Firms increasingly are tiering the service they provide to institutions; the smallest commission payers, like retail investors, get access only to printed reports through the firm’s Web site; firms that do more trading business are rewarded with access to analysts, salespeople and executives of the companies they cover. Because they trade more frequently than long-only clients, hedge funds tend to qualify for the higher tiers.
“There are some cases, particularly with the big firms, where they say, ‘You can’t talk to us because you’re not paying us enough,’” says Nicholas-Applegate’s Valeiras. “That’s fine. There’s plenty of information out there. We need to get it from different sources.”
The new economic environment also forces sell-side analysts to think differently. Because hedge funds, unlike most other institutions, frequently sell stocks short, analysts are working to identify overvalued stocks instead of simply generating buy ideas. Even their positive recommendations are becoming more short-term in nature and frequently are paired with offsetting positions in other stocks, a nod to the arbitrage-style trading that hedge funds often pursue. Often analysts won’t publish these ideas for fear of alienating their firms’ corporate clients. But in private conversations with paying customers, the sell ideas flow.
“They’re catering to the short side a lot more,” says Eric Green, senior managing partner and director of research at PENN Capital Management, a Cherry Hill, New Jersey–based manager of $4.9 billion in equity and high-yield-bond assets. “Analysts used to be afraid to talk about the stocks they didn’t like, but now hedge funds are paying them for short ideas. They’re not writing them up, but you call up and you can definitely get some ideas on the short side.”
The drive to please new masters perhaps most affects higher-level research services such as meetings with CEOs and one-on-one sessions at conferences set up by sell-side analysts. In many instances, hedge funds are crowding out traditional managers at such get-togethers.
“What I see more today is when I go to a conference or a management meeting, you have junior analysts from hedge funds sitting in and asking the CEO these really short-term-focused questions,” says Investors Group’s McClure. “We need to have access to some of that information flow because it affects stock prices, but what we’re far more interested in are the longer-term drivers of the business.” One analyst for a major mutual fund house combats this problem by insisting that hedge funds not be present at any such encounters that sell-side analysts offer to arrange for him. “If someone calls me and says, ‘Do you want to meet with so-and-so management?’” he explains,
“I always ask if there will be hedge funds there. If there are, I don’t go.”
Some firms are also experimenting with new structures and techniques to better serve hedge funds and other big commission payers. Lehman Brothers, Merrill and UBS are among the handful of firms that have assigned analysts to trading desk roles, where they no longer publish research but rather provide a small group of elite clients with trading ideas, often short-term in nature. Firms such as Merrill and Morgan Stanley have been building so-called specialist sales teams, in which institutional salespeople with deep knowledge of a particular sector market research to clients. These sector experts often are better equipped than generalist salespeople to recommend specific trading ideas and strategies, which can be helpful to hedge funds looking for short-term hits.
And hedge funds have no end of an appetite for research: In March the U.S. Department of Justice charged UBS research executive Mitchel Guttenberg with giving two traders advance notice of pending rating changes by UBS analysts in return for hundreds of thousands of dollars in cash. One of the traders allegedly used the information to make trades for three hedge funds he was associated with. The scheme, federal officials charge, had been going on for four years. UBS has placed Guttenberg on unpaid leave and is cooperating with authorities.
At the same time, traditional clients, like mutual funds, are under pressure to minimize transaction costs. Following a wave of scandals related to the trading of mutual fund shares and fund sales practices, as well as a bear market that depressed returns, fund boards and pension plan sponsors are pushing managers to cut back on the use of fund assets to pay brokerage commissions, which cover not just the cost of execution but also research and other bundled services. A few firms, like Fidelity, are making deals with brokers to pay commissions for execution only and cut separate checks for research. Most long-only managers are squeezing the Street for lower commission rates and more efficient, automated execution tools. Investment banks have little choice but to meticulously evaluate client profitability and tier their services accordingly.
“Our clients pound us about execution and commission levels, and the amount of commissions we’re paying has been going down,” says Nicholas-Applegate’s Valeiras. “It’s a less profitable business for the investment banks. They’re just acting rationally.”
As a result, even the biggest traditional money managers have had to alter their approach to research. Over the past four years, Investors Group has doubled its internal research staff, to 12 people, each of whom now covers about 15 to 20 stocks within one sector instead of as many as 60 stocks across multiple sectors. The firm also created a career track for analysts to become senior members with higher compensation; previously most analysts advanced to become portfolio managers. The Canadian fund giant can still get pretty much everything it asks for from brokerage houses but made the changes primarily because it feels sell-side research no longer provides the edge it once did, particularly after Reg FD. Its performance improved during the same period, says McClure.
Other firms have also adapted to Wall Street’s shifting priorities. Fidelity has instituted a similar change to recruit and retain research talent. Nicholas-Applegate is turning to regional brokers for research and paying them through commission-sharing agreements with agency brokerage houses like Investment Technology Group and Instinet Group. The firm reorganized its product offering over the past five years, cutting the number of portfolios from 50 to 24, but maintained a research staff of 50 that now focuses more intently on generating ideas for that smaller fund lineup. Internal researchers have built systems designed to isolate companies that are highly likely to revise earnings estimates upward or be taken private, among other events that boost valuations. During that period 85 percent of its portfolios have outperformed their benchmarks, says Valeiras. “We rely less on the sell side today,” he explains. “I’m much more comfortable because I control the resources instead of relying on outside resources.”
Meanwhile, developments on the retail side of the business have led big firms to turn their backs on the small investors they once pursued. The massive wealth creation of the past few years has left many individuals seeking advice on how to invest big sums of money. At the same time, the costs of running a retail brokerage operation have been rising rapidly. Amid tight competition, firms are upping their spending on broker compensation, as well as on technology and product development. To preserve their profit margins, these firms are going upmarket, leaving clients with less than six-figure portfolios to call centers, where they don’t always get access to the firm’s research, or to online discounters. Some of the discount brokerages, like Fidelity’s online arm, have sought to bridge this gap by offering third-party research to clients. But even these products tend to be quantitative in nature and best suited to active traders who want to use sophisticated analytics once reserved for institutions and other professionals. The 9-to-5-er with a family and little time for advanced research and stock picking has few, if any, options.
Of course, some would argue that such small investors should never attempt to enter the market on their own in the first place. Even professional money managers have a hard time beating the market, this reasoning goes, so individuals shouldn’t mess around with buying specific stocks unless they’re prepared to lose their money. The entire system of sell-side analysts making hundreds of buy and sell recommendations encourages investors to trade more than they probably need to. Even those who pick the right stocks can get killed on commissions, fees and capital gains taxes. That’s not exactly a smart way for people of modest means to put retirement and college savings to work. These folks, market sages such as Vanguard Group founder Jack Bogle have long argued, are better off in low-cost, passive vehicles like index funds and exchange-traded funds.
Postbubble reformers wanted to make Wall Street safe for the little guy. But their actions have contributed to a very different result: The little guy, both on his own and through intermediaries like mutual funds, must now invest without the help of the giant Wall Street firms that once catered to him.
