© Matt Kenyon

Back in the late 1990s, equity analysts were rock stars. Traders hung on their every televised prediction of just how high the latest dotcom stock would fly.

Today, they are endangered. Two decades of scandals, complaints about overly rosy ratings and regulatory tinkering have taken their toll. Research budgets have shrunk, the number of analysts and their relative experience have fallen sharply and research providers are consolidating to survive. AllianceBernstein’s research arm tied up with Société Générale last year and TD Bank recently bought Cowen.

Now, UK and EU policymakers are moving to undo much-vaunted 2018 reforms that sought to make sure investors got value for money from research. The question is whether anyone but a devoted CNBC fan should care.

Smart analysts can translate broad economic or political trends into clever trades, point investors to companies that are rising stars or hold management to account for financial promises. But the business model behind sellside research in particular has been deeply flawed for decades.

Rather than charging customers directly for their insights, big banks and brokers historically used research as a marketing tool and made money from it in sneakier ways. Investment bankers wooed corporate customers by promising favourable coverage from well-known analysts. Their brokerage arms, meanwhile, used research to drum up trading business. Fund managers and pension funds paid for access to the reports indirectly, by sending their stock and bond trades to the provider and paying extra-large commissions.

The problems with the first tactic became public in 2002, when Eliot Spitzer, then an ambitious New York attorney-general, revealed that star analysts had privately disparaged the stocks they publicly touted, using terms such as “dog”, “powder keg” or “POS”. Ten Wall Street banks paid $1.4bn to settle claims of biased research and US regulators severed the links between analysts and investment banking revenue.

More than a decade later, the EU — led by the UK, then still a member — banned the “bundling” of research with trading commissions, arguing that it was an opaque system that unfairly hid costs from ordinary investors.

While fund managers and pension funds are the main users of stock research, with bundling, they don’t pay for it or even disclose how much it costs. Instead, the outsized commissions that cover the research are built into the prices the funds pay for their stocks and bonds. That cuts into overall returns but is otherwise hard to measure. As part of the 2018 Mifid II reforms, the EU and UK began requiring fund managers to pay for research with direct “hard dollar” payments that had to be disclosed separately.

The immediate effect was positive for customers: commissions fell and most fund managers opted to eat the cost of research rather than raise fees. But the shift devastated research providers. Once analyst reports stopped, in effect being free, fund managers, already squeezed by competition from low-cost index funds, started slashing budgets. Spending on research has dropped 50 per cent since 2018, says Mike Carrodus, founder of Substantive Research.

Banks and brokers say unbundling has contributed to a wide range of market ills, including fewer analyst reports on small companies, the decline of small brokers and the shrinking number of listings on the London Stock Exchange.

With fewer analyst reports to draw attention to good ideas, innovative companies and key trends, funds end up getting worse results for their customers, they say. Smaller fund managers have it particularly badly, because they relied on the bundled model for access to a wider range of research than they can now afford.

Bringing back bundling, the industry argues, would help restore excitement about public companies, improve market liquidity and deepen capital markets. French, German and, more recently, some UK policymakers agree.

But sellside research has been on the decline for decades. Cuts in research spending are also pronounced in the US, where bundling remains legal and common, says Substantive Research.

The need to do better than index funds has forced active managers everywhere to slash costs and ensure that spending produces measurable returns. Online access to corporate stock filings, a wide variety of data and now artificial intelligence has raised the bar for original analysis, “There was a lot of money sloshing around. Did you really need that many analysts covering that many stocks?” Carrodus asks.

Yet innovative providers are thriving. Jefferies, which specialises in smaller companies that few other banks cover, is rapidly gaining market share. So is Expert Networks, which provides direct access to technical experts such as pharmacologists and chip developers. One of today’s few rock star analysts, economist Zoltan Pozsar, recently left a sellside perch at Credit Suisse to become an independent provider.

Even if bundling comes back, fund managers may not reopen the spigot for high commissions, especially for mediocre reports. “If you put on a price on something, it changes your behaviour,” says a US executive whose firm now gives each money manager a research budget. “It gets you questioning the value of the resources rather than just taking it.”


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Letter in response to this column:

Rock star analysts put on a show for trusting clients / From Alan Hearne, Woodstock, Oxfordshire, UK

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