“The Dying Business of Picking Stocks”

That’s the title of an interesting article in today’s Wall Street Journal on the accelerating replacement of active investing with indexing in portfolios of all stripes in the US.

One important factor in the lagging performance of most active investment groups is being left out, however.  It’s the one no active investment organization wants to talk about.

Beginning in the 1980s and increasing in momentum in the 1990s, active investment groups began to dismantle their in-house investment research departments.

Why do this?

In my view it’s because,

–research departments are expensive.  They’re hard to run well.  Evaluating securities analysts over short periods of time, like a year, is as much an art as a science.  Because of its pain-in-the-neck character, a less tha nstellar research effort is very easy to regard as an unneeded expense rather than a valuable asset

–most money management organizations are run by the chief marketing person, with the head portfolio manager being the Chief Investment Officer.  So the ultimate decision maker on firm-wide administrative matters is typically not an expert on what it takes to have sustainably good investment performance

–in the 1980s and 1990s brokerage firms built and maintained strong research departments, whose output they offered to money management clients in return for charging a higher commission rate for trades.  So reliable–although not proprietary–third party research was available to money managers without their having to pay for it from management fees.  This added to the view that good in-house research was unnecessary

–eliminating in-house research would mean salaries “saved” that could be used to boost compensation for the professionals who remained (including the CEO and CIO, of course).

 

Not every firm used all the reasons on this list, but many found some combination of them persuasive enough that they decided to substantially reduce, or eliminate their independent research entirely.

This, of course, made these firms radically dependent on brokerage research…

…which has proved a disaster when, in their dark days immediately after the stock market collapse of 2008-09, most brokerage houses laid off virtually all their experienced researchers and pared back their for-commission research efforts to the bone.

This left money managers who had eliminate their own research high and dry.  It also meant the affected firms were faced with the prospect of rebuilding their own in-house research.  Because this would involve a substantial expansion of the professional staff, the resulting expense would pressure income for–I think–at least a couple of years.

 

I haven’t followed this issue carefully.  My experience, though, is that this is the kind of decision CEOs really don’t want to make–to admit they were wrong, and badly enough that fixing their mistake will retard or eliminate future profit growth.  As a result, a kind of paralysis sets in and the process of fixing the error never begins.

 

 

the future of professional investment research unfolding

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.