Mainstreaming responsible investment via sell side research: EAI three years on
The Enhanced Analytics Initiative was brought into being three years ago by institutional investors to promote and directly fund sell side research that takes account of long-term performance factors. Raj Thamotheram (pictured right) evaluates its progress
It is an interesting coincidence that just as 10% of the global financial market declares its commitment to invest responsibly (1) it is experiencing the worst financial crisis in 60 years (2). With collateral damage from the sub-prime debacle still rolling through financial markets - not least the growing concerns about whether long-term investors will be able to fund their liabilities - investor attention is once again turning to the quality of sell side research and the role it plays in stock price formation.
Post Enron, WorldCom and other stock market scandals, reforms sponsored by former New York State governor, Elliot Spitzer, were supposed to have dealt with significant shortcomings in respect of the independence of sell side research.
However, since one of the most troubling aspects of the sub-prime meltdown is that some sell side houses knew about the extra-financial risk, used it in their proprietary trading work (ie, for their own benefit) and did not publish, it is not surprising that searching questions are once again being asked of this important element of the investment supply chain. Its cause is not helped by the fact that Innovest, an independent specialist research organisation, appears to have been the only research agency that called the sub-prime problem (in print) ahead of the crisis.
Given the role of the sell side in the formation of stock prices, unless it pays due attention to the extra financial performance of the companies it researches and rates, the ability of fund managers and asset owners to integrate consideration of environmental, social and social (ESG) issues into investment decisions will be unnecessarily delayed, the signal sent to corporate management in respect of the ESG performance will be concomitantly weaker, and the likelihood of undue stock market volatility will persist. In brief, the hopes of mainstreaming responsible investment will be derailed.
That is why the Enhanced Analytics Initiative (EAI) - which sees buy side firms and asset owners united in explicitly rewarding sell side research organisations that produce good quality research on extra financial factors such as ESG issues - is so important. EAI stands out in making a meaningful contribution to effecting market efficiency and reducing the unnecessary volatility in stock market returns that comes from the presence of critical information gaps in respect of long-term corporate health and performance. It does this by providing sell side research firms with financial and reputational - rather than regulatory - incentives to improve standards.
A nice theory
In theory the sell side has much to offer the financial system. Imagine, for instance, a world where investment analysis was fully decentralised and distributed among each and every fund management firm. This would not necessarily be a bad thing in terms of the information discovery that fosters market efficiency: tens, if not hundreds of thousands, of self interested analysts on the trail of the data that would enable them to outperform each other.
But from a financial system perspective, it would represent a massive duplication of effort. It would also be impossible to manage for the directors and senior executives on the receiving end of investor enquiry and so would break down. Most importantly, it would be a sure-fire way of ensuring that the information that cost so much to gather would end up pooling within some data gatherers rather than being disseminated across the market. This is why we would have to invent something like sell side research if it did not exist.
For all its weaknesses, sell side research is a massively efficient centralised resource, motivated to gather and to share investment relevant information. Like their buy side clients, sell side analysts are motivated to be right - perhaps even more so given the smaller jobs market in which they work. Crucially, they are also motivated to be public and loud about their opinions.
Sell side data flows, and, in many instances, is pushed through the financial system. The sell side can therefore have a large effect on market perceptions about particular stocks; in contrast the buy side has much less to gain from sharing data with others and is largely motivated to secrecy. This means that the sell side makes a vital contribution to market efficiency: the collective intelligence of the market, which aggregates the divergent opinions of its constituents into price setting, is at its best in the presence of shared learning about stock price formation, which sell side transparency facilitates, and when information is widely available at low cost.
Also, corporate management is clearly influenced by sell side analysts and their expectations. The five or 10 top sell side analysts in each sector have unrivalled access to senior management. So if an issue is on the agenda for these analysts, it will be taken very seriously at board level where directors often use sell side research as a way to check what they are told by management. This is important when sell side research runs counter to current financial valuations, such as Deutsche Bank’s famous study on GMO which effectively called the demise of Monsanto.
The inconvenient truth
If an issue is not on the sell side agenda - or worse, if top-ranked analysts say or simply just act as if it is irrelevant - this sends a strong, negative message to management that can lead to misallocation of attention, and thus capital, at all levels.
In a recent Deloitte survey in co-operation with the ‘Economist Intelligence Unit, In the Dark, What Boards and Executives Don’t Know about Their Businesses’, more than 90% of respondents said a number of areas of their business whose health cannot be measured in monetary terms are critical or important drivers of success: customer satisfaction, product/service quality, operational performance (ie, the efficiency and effectiveness of key business processes), employee commitment, and governance, and management processes. Nevertheless, over 60% of these managers rate themselves only average, fair or poor in measuring and monitoring these factors.
In a similar study, McKinsey & Co found that more than 50% of directors admitted to having only a limited sense of their company’s prospects over the next five-10 years and only 4% said they fully understood their company’s long-term prospects.
Why such little attention to these critical corporate health factors? One answer comes from Graham, Harvey and Rajgopal at Duke University, who have shown that a significant majority of CFOs are prepared to sacrifice profitable long-term projects simply to hit the quarterly numbers embedded in analysts’ consensus expectations.(3)
The problem, of course, is that if the sell side generally ignores certain aspects of corporate performance - such as Rentokil’s human capital management culture, BP’s health and safety performance, Siemens’ corporate culture or the culture of risk management at investment banks - then the collective intelligence of the market and its allocative efficiency suffers from the related information gap.
Equally as significant, investors cannot expect to stock pick their way out of trouble when the problem is a systematic issue that the sell side does not give due recognition. And as experiences such as WorldCom, Exxon, dotcom and sub-prime keeps reminding us, these systemic risks can be very costly.
EAI’s role in preventing market failure
Prior to the formation of EAI, just a handful of sell side houses allocated resources to filling the information gap in securities research. Thanks to the economic and reputational influence of EIA’s 27 institutional members, who together have assets of over $3trn (€1.9trn), the number of research houses covering extra-financial factors has increased significantly over the last three years, relevant research from analysts in Australia and Asia is increasingly common, and there has been a significant increase in the quantity and quality of this research.
The presence of sell side houses at almost all responsible investing events today is indicative of the credibility they have with asset owners as much as fund managers. In addition, and as explained by the behavioural concept of ‘defensibility’, good sell side commentary on extra-financial performance is giving mainstream buy side and asset owners confidence to factor relevant ESG issues into their investment decisions.
Of course, other factors have also contributed to this development but most sell side staff are clear that EAI has been a critical factor - if not the defining factor - in getting the necessary management support and extra financial resources.
Work in progress on the sell side
It should come as no surprise, however, that there is much yet to be done. For example, several brokers with whom EAI members have strong commercial relationships continue to produce stand-alone reports - meaning that even their most important ESG conclusions are not routinely reflected in the mainstream notes that shape consensus numbers and opinion.
Why is change so difficult and yet so important? As William Donaldson, a former analyst and SEC chairman has said: “To state an obvious, but often overlooked fact - quarterly earnings do not reflect companies’ long-term viability. Identifying the factors that will drive long-term growth - such as personnel, strategy, financial strength and flexibility, internal corporate governance, innovation and customer service - may be more difficult to quantify, but they offer a more accurate and more complete portrait of a company’s future.”(4)
If mental models are an impediment to change, an even bigger one would appear to be sell side research business models. Worryingly, some sell side houses have regressed and lost specialist staff during EAI’s lifetime. Despite repeated requests for better corporate governance coverage, progress has been slow in this important area. Indeed the one house that had such expertise has recently lost it. This raises questions whether sell side firms are in fact able to address the conflicts of interests that hinder such ‘sensitive’ commentary or whether EAI and others will have to focus on independents.
A related issue is that coverage of North American market remains very weak with some houses still struggling to secure the intellectual engagement of their US-based analysts - one of the reasons perhaps for why the sub-prime contagion started there. And ESG coverage of sectors can bear little relevance to market weightings - over its three year life span, EAI members have seen approximately 50 auto sector reports but only 25 banking sector reports they considered appropriate for evaluation.
Finally, credit rating agencies, who, interestingly, were not included in the EAI process, have made very little progress on extra-financial risk assessment, which is an indicator of what EAI has achieved and what still requires attention.
Work in progress on the buy side
In addition, there are some on the buy side who are yet to be convinced about the merits of the initiative, despite its success. Some argue that they do not depend on sell side research and are therefore reluctant to reward it explicitly. The reality, however, is that few buy side firms have unbundled, even fewer have stopped paying for research completely and this author has yet to hear of a firm that never meets sell side analysts. Others assert that, as good analysts, they already see and reward good ESG research.
While one can never know for sure, it is difficult to reconcile the average quality of sell side research on ESG matters with the number of managers who assert they are rewarding such research. Indeed, this claim is not dissimilar to the claim that all fund managers naturally integrate ESG factors or naturally beat their benchmarks. Both are viewed with some suspicion by informed clients.
What is certainly true is that changing allocations to sell side is an intensely political issue, so it is not surprising that other reasons are used to explain an understandable resistance to change.
It is also true that many portfolio managers do indeed ignore the output from a given sell side valuation model when they come to making stock decisions. Although such valuation models can be an important resource for some buy side firms, what many experienced buy side analysts want is better access to the raw data that the sell side has gathered and better access to the sell side analysts for the bespoke and deeper data dives they can facilitate, for their thinking about the variables in the valuation equation, and for easier access to key corporate executives.
Since it is such information exchange that promotes the market efficiency that all active investors rely on to ensure that the mispriced stocks they invest in gravitate towards their proper valuations, access to the right sell side research is worth rewarding. The bottom line is that if extra-financials have been forgotten from that calculation of fair value, the buy side will generally transmit that failure.
Towards a tipping point
As with any successful growing project, especially where the context itself is fast moving, there also comes a time to review the design of EAI.
The initial design - which focused on a specific percentage to be allocated to a small list of winners - served its purpose well and created momentum for change. Before EAI, there were a small number of reports of variable quality. Now there are many reports, many of which are of good quality. In parallel, there are many more analysts at both the sell and buy side houses who are improving the quality of information flow on ESG matters.
The critical opportunity now - and bearing in mind that there are many different and equally valid models of buy side organisations - is to ensure that integrated extra-financial research is readily accessible to buy side recipients. This, of course, includes RI specialists but the biggest challenge is to get relevant extra-financial analysis direct to the mainstream analysts. Given the limited time they have for reading reports and talking with their sell side counterparts, the solution is to genuinely embed analysis of material ESG issues into the normal research process. And linked to this, the other critical challenge is to ensure that those sell side houses that move in this direction are rewarded for so doing in a way that their analysts and senior management value and can track.
How to achieve this will require creative strategic thinking. The decisions will need to be taken by the current members of EAI but this is a good opportunity for asset owners and fund managers who have - for whatever reason - not yet joined EAI, and for sell side and independent research houses to make their input.(5)
Uniquely, EAI gives long-term investors who care about the integration of extra-financial factors into the research process a practical way to put their words into effect. This is particularly relevant to the members of the Principles of Responsible Investment (PRI), the majority of whom are not yet members of EAI but who have made a commitment to encourage integration of ESG analysis by their supply chain and to report on this.
Once PRI’s $13trn - which as previously noted accounts for $1 out of every $10 in the financial system today - starts really to speak on this issue, we will be at or very near the tipping point where stock market valuations come to reflect extra-financial performance, and where corporate management embraces a holistic perspective of corporate performance.
While the focus for asset owners and fund managers is rightly on more accurate pricing of risk and reward, we should not ignore the wider benefits of this change.
As respected US commentator William Greider notes: “A transformation of Wall Street’s core values is not only possible, but eventually likely to occur…Though this will take many years (maybe decades) to achieve, it would represent a generational accomplishment more enduring and meaningful than any of the current preoccupations of politics, since the very foundations of public life would be altered.”(6)
Why is someone who has been so critical of Wall Street so optimistic? “Within the monolith of finance some adventurous players are always experimenting with new methods and theories, trying to take profit from what the larger herd doesn’t yet see or understand. When renegades succeed, the system typically steals their ideas and tries to emulate their approach,” says Greider.
Focused on one small but critically important aspect of this wider agenda - namely the need for more rounded sell side research - and with the impact of sub-prime on our clients fresh in our minds, EAI members are committed to making sure this
transformation is a matter of years rather than decades.
It is for this reason that we would welcome the support of peers in speeding this process along.
Raj Thamotheram is director of responsible investment at AXA Investment Managers
(1) Members of the Principles of Responsible Investment collectively account for $13trn.
(2) ‘The worst market crisis in 60 years’, George Soros, Financial Times, 23 January 2008
(3) ‘Value destruction and financial reporting decisions’, John Graham, Campbell Harvey and Shiva Rajgopal, September 2006
(4) William H Donaldson: Remarks to the CFA Institute Annual Conference Philadelphia Pennsylvania, 2005
(5) Suggestions should be sent to Peter Scales, chairman, EAI. E-mail:firstname.lastname@example.org
(6) ‘Soul of Capitalism: opening paths to a moral economy’, William Greider, Simon and Schuster, 2004