brokers’ post-recession adjustments…

It doesn’t seem that long ago that Guy Moszkowski, top-ranked analyst of brokerage house stocks on Wall Street, shocked his colleagues by leaving Salomon for Merrill.  This was during one of Merrill’s on-again, off-again attempts to build a competent research effort to complement its powerful Thundering Herd sales force.

Don’t get me wrong.  There are excellent analysts at Merrill.  But my take on the firm is that its heart has always been in sales.  Its attitude is that three so-so analysts are a better use of the firm’s money than one research star.

Mr. Moszkowski is now leaving Merrill, according to the Wall Street Journal.  Where is he going?   …to Autonomous Research, a UK-based independent research boutique specializing in banks.

He’s the latest in a long line of similar departures from the big sell-side firms, as Wall Street brokers dismantle the research departments they built up over the past fifteen years or so.  Brokers are convinced that research is a chronic loss maker they can no longer afford to subsidize in an austere post-Great Recession era.

…are causing problems for mid-sized money managers

A generation ago, equity money management firms all had large in-house staffs of securities analysts who supported their portfolio managers.  Having your own “proprietary” analysis was considered to be a vital point for selling services to both retail and institutional investors.

In reality, these buy-side research departments were:

–expensive

–very difficult to manage

–even more difficult to train and upgrade, and

–inevitably a mix of skilled and creative, along with mediocre and pedestrian.

During the 1990s, money managers discovered that they could lay off most (or all) of their own analysts and replace them with research bought from brokerage houses.  Figure–to pluck a figure out of the air–that it costs a firm $250,000 yearly to support one analyst.  Lay off 10 and the company saves $2.5 million a year that would otherwise come from the fees clients pay to their managers.

Better still, money management firms could “pay” for brokerage research with clients’ money–by letting the broker to charge higher-than-normal trading fees for specified transactions (a practice called “soft dollars,”  as opposed to “hard dollars,” i.e., payments in cash).  Best of all, clients didn’t seem to mind either the disappearance of in-house analysts or the fact that they, rather than the money manager, were now footing the bill for investment research.

So all but the largest money management firms did just that.  They eliminated, mostly or entirely, their own research departments.

But the brokerage research departments have been gutted over the past few years.  What do those money managers do now?

rebuilding in-house research?

I think that’s the only solution for money managers who want to stay in business for themselves.  But that’s much easier said than done.

I guess it’s possible to string together a “virtual” brokerage analyst network by doing business with a bunch of the little independent research boutiques that have sprung up recently.  But many of the best sell-side analysts now work for hedge funds, venture capital or private equity.  So there’s no guarantee you’d end up with enough coverage.  Also, there’s no reason to believe that your information network would stay together for long (a topic for another post).

Another issue:  money managers are paid a percentage of their assets under management as their fee for services.  For many traditional money managers assets under management are much lower than they were a half-decade ago.  Assets are also shrinking.  Institutional clients are taking money away from traditional managers and giving it to hedge funds.  Retail clients continue to fund their 401ks, but they’re shifting their taxable money and their IRAs to lower-cost  index funds and ETFs.

So where will the money for securities analysts come from?

Let’s say a small money management company has $2 billion in assets under management.  Let’s say it collects a management fee that averages 0.5% of assets.  That’s $10 million a year.  Take away $1 million a year for sales, general and administrative expenses.  That leaves $9 million, most of which will be split among the professional employees of the firm.

Let’s say the firm needs six securities analysts + a research director to create a bare-bones research department.  At $250,000 per analyst (including office space, travel …) and $500,000 for the research director, that comes to $2 million a year, reducing operating income by almost a quarter.  This implies everyone at the firm takes a 25% pay cut to get research up and running.  …which is a recipe for having the best talent abandon ship.

For a host of reasons, it’s probably better to merge with another comparably-sized management company.

what’s important for you and me

Don’t go to work for a small money manager expecting a job for life.

The quality of aggregate buy side research is going to get worse, not better.  This instability will mean continuing high market volatility as professionals end up reacting to news they didn’t anticipate.

Less efficient markets mean more scope for ordinary individuals like you and me to know more about specific stocks than professionals.  This means more chance of making market-beating gains.