Since April 2003, when ten of the largest Wall Street Investment banks agreed to pay $1.4 billion to
settle charges brought by New York attorney general Eliot Spitzer that its analysts had betrayed
investors during the late 1990s boom, Wall Street research has been in a state of turmoil. Analyst pay
has been slashed in half-or more. Highly paid stars have been ushered out the door, replaced by
junior analysts. Most big research departments have shrunk by more than a third.
But more profound changes are coming, because Wall Street research finds itself under a far graver
threat than even Eliot Spitzer: Its business model is under assault. Dozens of new research boutiques
have cropped up in recent years claiming to offer truly independent research.
Clearly, merely downsizing research departments will not be enough to stave off the coming crisis. It is
going to require a fundamental rethinking of the entire business.
As is usually the case with Wall Street, the grand philosophical questions are prompted by hard-core
economic questions. The first is, How much is research worth? The second: How is it going to be paid
for?
Because research costs are folded into trading commissions, securities analysis has often been
thought of by investors, institutions and individuals alike-as a freebie. But it’s not free; a percentage of
every commission dollar covers research costs.
The buy side is demanding that the costs of research be quantified-and the sell side is quaking at the
thought of it.
“Research has faced 6% annual compounded price deflation for the past 30 years.” But for much of the
‘80s and early ‘90s, the decline in commissions was somewhat offset by the increase in trading
volumes.
With the stock market boom that began in the mid-1990s, research changed again-and once again,
the change was driven by the economics. By then, even huge trading volumes couldn’t make up for
ever-declining commissions, which were under 10 cents a share.
Just in the nick of time, though, research found its new rationale. It found investment banking.
The essential purpose of research, to give untainted investment advice, became utterly corrupted-but
in purely economic terms, it made perfect sense. Investment banking generated tremendous
revenues, and if research could take credit for bringing in some of that money, it could justify itself in
an era of dwindling commissions.
Nonetheless, investment banking compromised the independence of analysts.
Did individual investors understand that Wall Street research had lost its independence?
Most likely no.
But at the big buy side institutions, fund managers absolutely understood how corrupt research had
become. Yet-and this is the key point-they continued to pay for it with their commission dollars.
“There was no market mechanism to punish bad research,” says Scott Cleland: Thus the issue of how
much buy side was paying for research vs. how much value that research truly provided-became
extremely muddy. And into that morass walked Eliot Spitzer.
You can scarcely talk to an analyst these days without hearing about all the new rules that emerged
from the Spitzer settlement.
Indeed, if all Spitzer had done was set up new rules, it seems likely they would quickly become
ineffective as Wall Street searched for loopholes. But Spitzer did something far more powerful: He also
separated banking and research economically.
Thus, research is back to one revenue stream again-trading. And trading commissions are lower than
ever-under 5 cents a share for a full-service “bundled” commission.
Then Spitzer did something else. After he’d finished with Wall Street analysts, he turned his attention
to mutual funds, where he uncovered the next big scandal: insiders who market-timed and late-traded
mutual funds.
The mutual fund scandal is likely to affect the future of Wall Street research as much as Spitzer’s
analyst investigation. Why? Once again, it is going to change the underlying economics of research.
When Spitzer exposed the nasty secrets of the fund business, he also raised awareness about fund’s
hidden costs to shareholders. One of those costs, clearly, is full-service commissions. (It’s also
sometimes called soft-dollar compensation-the practice of diverting a portion of commissions to cover
the cost of research.)
In the wake of the mutual fund investigation, some fund companies-along with the SEC-began asking
the tough questions about research and commissions they had ducked all these years. How much
were they truly paying for research with their commission dollars? Given that electronic exchanges can
now execute trades for a penny a share, was that additional 4 cents too much to be paying full-service
trading desks? Some companies, notably Fidelity Investments, even began asking whether it was
more appropriate for funds to pay for research out of their own pockets instead of having
shareholders pay for it through commissions.
Fidelity has been in talks with most of Wall Street, essentially demanding that the firms begin
quantifying how much of their commissions are going for research.
Fidelity is hardly the only company trying to reform the soft-dollar system. There have been numerous
ideas put forward, including the most extreme of all: eliminating the system entirely and having the
buy side pay cold, hard cash for research.
And how will transparency affect securities research? Everyone on Wall Street knows the answer:
Disclosing how much the buy side is paying for research will cause the buy side to pay less-a lot less.
And that’s the game right now: figuring out how to produce research that is unique enough-and
valuable enough-to survive the arrival of transparency.
Meanwhile, dozens of new, independent boutiques have arisen in the past few years, all of which
think their models will be among the winners. Some are angling for a piece of the $432 million
settlement pie that is going to independent research; others think that’s fools gold, and they’re better
off concentrating on the institutional market. All of them are claiming that their research is inherently
superior to the research being produced by the big Wall Street firms.
Regardless: “The old research model is dead.” A new model with more stable economics needs to be
implemented as research coverage on Wall Street continues to be rationalized.
And small-cap stocks are precisely the ones that have been abandoned by the big firms as they’ve
shrunk their research departments. Enter the new era, Independent Research as a complement to fill
this void.
settle charges brought by New York attorney general Eliot Spitzer that its analysts had betrayed
investors during the late 1990s boom, Wall Street research has been in a state of turmoil. Analyst pay
has been slashed in half-or more. Highly paid stars have been ushered out the door, replaced by
junior analysts. Most big research departments have shrunk by more than a third.
But more profound changes are coming, because Wall Street research finds itself under a far graver
threat than even Eliot Spitzer: Its business model is under assault. Dozens of new research boutiques
have cropped up in recent years claiming to offer truly independent research.
Clearly, merely downsizing research departments will not be enough to stave off the coming crisis. It is
going to require a fundamental rethinking of the entire business.
As is usually the case with Wall Street, the grand philosophical questions are prompted by hard-core
economic questions. The first is, How much is research worth? The second: How is it going to be paid
for?
Because research costs are folded into trading commissions, securities analysis has often been
thought of by investors, institutions and individuals alike-as a freebie. But it’s not free; a percentage of
every commission dollar covers research costs.
The buy side is demanding that the costs of research be quantified-and the sell side is quaking at the
thought of it.
“Research has faced 6% annual compounded price deflation for the past 30 years.” But for much of the
‘80s and early ‘90s, the decline in commissions was somewhat offset by the increase in trading
volumes.
With the stock market boom that began in the mid-1990s, research changed again-and once again,
the change was driven by the economics. By then, even huge trading volumes couldn’t make up for
ever-declining commissions, which were under 10 cents a share.
Just in the nick of time, though, research found its new rationale. It found investment banking.
The essential purpose of research, to give untainted investment advice, became utterly corrupted-but
in purely economic terms, it made perfect sense. Investment banking generated tremendous
revenues, and if research could take credit for bringing in some of that money, it could justify itself in
an era of dwindling commissions.
Nonetheless, investment banking compromised the independence of analysts.
Did individual investors understand that Wall Street research had lost its independence?
Most likely no.
But at the big buy side institutions, fund managers absolutely understood how corrupt research had
become. Yet-and this is the key point-they continued to pay for it with their commission dollars.
“There was no market mechanism to punish bad research,” says Scott Cleland: Thus the issue of how
much buy side was paying for research vs. how much value that research truly provided-became
extremely muddy. And into that morass walked Eliot Spitzer.
You can scarcely talk to an analyst these days without hearing about all the new rules that emerged
from the Spitzer settlement.
Indeed, if all Spitzer had done was set up new rules, it seems likely they would quickly become
ineffective as Wall Street searched for loopholes. But Spitzer did something far more powerful: He also
separated banking and research economically.
Thus, research is back to one revenue stream again-trading. And trading commissions are lower than
ever-under 5 cents a share for a full-service “bundled” commission.
Then Spitzer did something else. After he’d finished with Wall Street analysts, he turned his attention
to mutual funds, where he uncovered the next big scandal: insiders who market-timed and late-traded
mutual funds.
The mutual fund scandal is likely to affect the future of Wall Street research as much as Spitzer’s
analyst investigation. Why? Once again, it is going to change the underlying economics of research.
When Spitzer exposed the nasty secrets of the fund business, he also raised awareness about fund’s
hidden costs to shareholders. One of those costs, clearly, is full-service commissions. (It’s also
sometimes called soft-dollar compensation-the practice of diverting a portion of commissions to cover
the cost of research.)
In the wake of the mutual fund investigation, some fund companies-along with the SEC-began asking
the tough questions about research and commissions they had ducked all these years. How much
were they truly paying for research with their commission dollars? Given that electronic exchanges can
now execute trades for a penny a share, was that additional 4 cents too much to be paying full-service
trading desks? Some companies, notably Fidelity Investments, even began asking whether it was
more appropriate for funds to pay for research out of their own pockets instead of having
shareholders pay for it through commissions.
Fidelity has been in talks with most of Wall Street, essentially demanding that the firms begin
quantifying how much of their commissions are going for research.
Fidelity is hardly the only company trying to reform the soft-dollar system. There have been numerous
ideas put forward, including the most extreme of all: eliminating the system entirely and having the
buy side pay cold, hard cash for research.
And how will transparency affect securities research? Everyone on Wall Street knows the answer:
Disclosing how much the buy side is paying for research will cause the buy side to pay less-a lot less.
And that’s the game right now: figuring out how to produce research that is unique enough-and
valuable enough-to survive the arrival of transparency.
Meanwhile, dozens of new, independent boutiques have arisen in the past few years, all of which
think their models will be among the winners. Some are angling for a piece of the $432 million
settlement pie that is going to independent research; others think that’s fools gold, and they’re better
off concentrating on the institutional market. All of them are claiming that their research is inherently
superior to the research being produced by the big Wall Street firms.
Regardless: “The old research model is dead.” A new model with more stable economics needs to be
implemented as research coverage on Wall Street continues to be rationalized.
And small-cap stocks are precisely the ones that have been abandoned by the big firms as they’ve
shrunk their research departments. Enter the new era, Independent Research as a complement to fill
this void.
Stock analysts are facing a far graver threat than New York attorney
general Spitzer: Their business model is under attack. And they need to
find a new one-fast.
Source: Fortune, June 14, 2004.
general Spitzer: Their business model is under attack. And they need to
find a new one-fast.
Source: Fortune, June 14, 2004.
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fundamental, material, primary, notable, imperative, outstanding, critical, capital, chief and
foremost. We believe these definitions best describe the character of our firm.