The Changing Face of Equity Research
One of Wall Street’s oldest and most prestigious industries is set to undergo a major transformation over the next few years, but what this means for the research industry and its clients is unclear. Wall Street analysts conduct research on equities, credit, the macroeconomy, among other areas, often specializing in one specific sector or subsector. For example, within a major research firm’s equities division, there will be multiple senior analysts covering technology stocks, with one senior analyst specializing in software companies, another in hardware companies, and another in consumer technology. These “sell-side” research analysts publish research and access to other investment ideas to clients on the “buy-side”. The buy-side is comprised of hedge funds, asset managers, and other institutional investors, who pay for the research and access to the analysts, since they value the research as well as the relationships that the analysts have with the management of the companies in the industry that they cover.
In analysts’ reports, they will discuss industry trends, company trends, and report on companies’ financials. They’ll also assign a rating to stocks, calling them either a buy, hold, or sell depending on whether they think their clients on the buy-side should invest in these companies or avoid them. Most major Wall Street banks, as well as many independent research shops, have sell-side research divisions.
Traditionally, the buy-side hasn’t actually paid for research itself, but instead pays commissions and fees to banks to use their services, including buying and selling new shares of stock via the bank. Analysts’ research has been financed by the commissions and fees, albeit in a very indirect way. As a result, it has been extremely difficult to quantify analysts’ success in forming relationships with clients on the buy-side, as well as with their stock ratings, since they’re not getting paid directly on their successes in these two areas. For example, an analyst who has a 90% success rate with his buy rating—meaning companies that he assigns a buy rating to go up 90% of the time—won’t make more money than an analyst who only has a 30% success rating, since they’re being paid indirectly and not being paid based on how successful their ratings are.
Where things might change is with the European Union’s Markets in Financial Instruments Directive (MiFID) regulations, specifically MiFID II. These regulations, which are set to take effect in January 2018, will mandate that the buy-side pay specific commissions for research that will be independent of other fees and commissions they pay to banks for other services. This new payment structure should fix the aforementioned difficulties with quantifying analysts’ success in forming relationships with the buy-side, and with getting ratings calls correct.
However, problems with the new model have started to emerge, including one issue raised by Jonathan Hurewitz, the COO of UBS’s investment management division. The issue he raises is that today, analysts publish their research by sending out their reports to all their clients. Since all their clients pay the same fee—in essence no fee because the buy-side doesn’t pay directly for research—they all receive the research at the same time. With the new payment mode, clients will pay different commissions or subscription amounts, and will be given access based on how much they pay. Where this really becomes a problem is that sometimes, analysts’ comments will actually change the price of a stock. For example, when an extremely influential and successful analyst at a major bank changes his rating on a stock, or raises his price target, it shows that he believes the stock price will rise. When the buy-side acts on this new information and purchases the stock, the increase in demand will actually cause the stock price to rise. In cases where the analyst is influential and does have the power to move the stock, since clients who get this information first will evidently have the opportunity to purchase the stock at a lower price, how do analysts choose which clients get information first? Is it fair that clients who pay more will get the opportunity to find out this information first and therefore have the opportunity to purchase the stock at the lower price?
Sell-side research analysts play a pivotal role as the liaisons between the buy-side firms that purchase stock in publicly traded companies and the management of the publicly traded companies themselves. As the industry’s payment plans change, it’ll be fascinating to see what the effect is—if any—on research as a thriving industry on Wall Street.