Pressure For Positive Change – Option B
By: Raj Thamotheram
When it comes to investment research, the sell side analysts define the kind of research that is produced for the buy side. However, Raj Thamotheran, of the EAI steering committee, says long-term investors, such as pension plans, need a better balance.
At the heart of the market-based global financial system is a paradox. Customers at each point in the investment chain have less power when dealing with their suppliers than is the case in many other corporate sectors! It is true that there is a wide choice of different brands, but the product range is often limited and may not include the services that are really needed.
This is clearest in the area of investment research, where sell side analysts define the type of research that is produced and supplied to the buy side. In order for long-term investors, such as pension fund managers, to appropriately manage the risk and return on their investments, a better balancing of power is required. For clients who want to be responsible long-term investors, the solution is clear. We need to be more proactive and make clear what type of research we are willing to pay for.
Shift In Power
Arguably, this shift in power has been needed for a long time, so why is it happening now? One reason, no doubt, is that there is greater public awareness of the problems related to research by the traditional suppliers – research units owned by investment banks. But this is not the only factor. Long-term investors and, in particular, pension funds are starting to become much more focused on their core purpose – providing absolute pensions. Inevitably, this is increasing attention on absolute risks and returns. In parallel, there are growing pressures on investors, who believe they are not short-term traders, to encourage company management to take a long-term perspective on wealth creation, and not one which simply boosts share price in the short-term.
Within the ménage a trois of senior corporate management, sell side, and buy side, there is endless potential to engage in a blame game about who is really responsible for the short-termism. Such conversations have little positive value. The solution is for all parties to take responsibility for their share of this dynamic and do what they are uniquely suited to do to address the challenges.
For the buy side, this means being willing to pay for research that provides a more rounded perspective on a company (for example, research that evaluates drivers of competitive values and risk). While there is on-going debate about the best term to use to describe these factors – ‘intangibles,’ ‘extra-financials,’ ‘enterprise risk management’ — academic research has shown that these factors can be crucial to the valuation of a company. Research on extra-financial issues may throw light on how well the company is positioned, looking forward and in comparison with its competitors, on issues which are not traditionally analyzed, but which have impact on corporate profitability. If these happen to include human capital, brand reputation, or other hard-to-evaluate aspects of corporate performance, the solution is not to give up without trying. Instead, it is to actively look for creative, innovative ways to bring these factors into financial models and so evolve the analyst’s professional tool-kit. If enough of the buy side adopts this approach, good sell side analysts will begin to focus less on the quarter or the next six month cycle and more on the long-term.
Meet This Challenge?
Will the sell side be able to meet this challenge? It is true that broker analysts have,as a rule, not been well-informed on these issues. But, equally, they have had no incentive to develop such capacity, since they are paid on transactions and capital utilization rather than value creation. But this is changing.
Research from Mercer Investment Consulting shows that Canadian investment managers view environmental, social, and corporate governance issues of growing importance in corporate performance (see Table 1). Although the desire for integrated research still lags behind that of Europe, most Canadian fund managers surveyed consider these issues likely to become material in the near future. More directly, the ‘Enhanced Analytics Initiative (EAI),’ a global collaboration between large asset owners and fund managers, has raised the stakes by actively seeking to create a market for research into intangibles. Members of this group have agreed to allocate a minimum of five per cent of their individual broker commissions to certain, approved brokers which provide the best research on extra financial issues. The aim of EAI is to provide a financial incentive to encourage the sell side to focus more of its research on these issues.
Assuming EAI reaches critical mass, the initiative will certainly help to solve important challenges facing all players in the investment chain. Specifically, by pooling influence, the initiatives should:
- Identify brokers that are most dynamic in providing differentiated research that helps generate alpha in particular sectors and markets
- Provide investment insight relevant for mandates which have a fundamental research approach or that have absolute risks/returns or unconstrained mandates
- Provide investment ideas for managers looking to short stocks on the basis of the market not pricing in risk which can be anticipated
- Provide the research which would allow more objective prioritization of engagement activity with companies (for example, for those investors who adopt an active owner perspective)
- Ensure corporate executives are challenged on a more complete set of issues which drive risk and reward, and so reduce the tendency for investment professionals to focus on short-term share price movements
EAI is an important move in the right direction. What is needed now is for more members in more markets to help create a stronger business case for more brokers to respond.
Needs Are Met
Asset owners the world over are becoming more professional in their understanding of the investment process and more confident in seeing that their needs are met. The Canadian Association of Pension Supervisory Authorities Pension Plan Governance Guidelines is one example. For similar reasons, asset owners have a strong case for wanting their fund managers to join EAI or at least evidence that they have an active and credible approach to making sure these research needs – on all extrafinancial issues and in all markets where investment happens – are being met.
Asset owners who are paying active management fees – hoping to get alpha from their fund managers – have a particular interest in knowing that their managers have the best information feeds possible as it is client money that is being spent on brokers. Some asset owners feel so strongly about EAI that they have chosen to join as “associate members.” Several have already made clear their intention to consider membership of EAI as one criterion in future mandates and beauty parades.
But even where asset owners have a significant passive allocation, EAI adds value in the same way that public health strategies contribute to personal health. Passive investors have a strong interest in seeing the gap between market price and true fair value close and that risk and reward be more accurately priced in across their diversified portfolio. When this does not happen, it is mostly the end beneficiaries and plan sponsor that carry the costs. As research stimulated by the EAI becomes more common, market efficiency should improve.
Fund mangers also have their own reasons for wanting to join EAI. Finding new ways to avoid risk, new sources of alpha (or at least avoid ‘negative alpha’), and help with new activities (for example, engagement and active ownership programs) are increasingly important for many fund managers, especially those who take a fundamental and long-term investment approach. In joining EAI, fund managers are also saying that they are confident enough to acknowledge that trust in investment intermediaries is at a low point and that where it is possible to better align internal processes with end beneficiary interests, as is the case with EAI, then they are willing to overcome the internal cultural obstacles to change and see it implemented.
All of the above means that it is crucial that the EAI succeeds in attracting investors from all markets. The initiative started in Europe but is just as relevant in North America. More incentives for the sell side to produce more meaningful research can only result in better investment decisions and more benefits for more end beneficiaries.
Raj Thamotheram is chair of the EAI steering committee and senior adviser for responsible investment at USS Ltd.
- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -