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The Dog Ate My Alpha: Why Research Might Matter More in 2015

November 17th, 2014

We have all heard that most active investment managers tend to under-perform their relevant market benchmarks.  And while this trend seems to have continued in 2014, there are some studies which suggest that investment research aimed at helping portfolio managers pick stocks could be a big driver of performance in 2015 and beyond.


Poor Asset Manager Performance Continues

According to Standard & Poor’s regular report cards, actively managed domestic mutual funds have a rather dismal record when compared with investing in passive indexes.  In 2010 58% of all domestic mutual funds underperformed when matched against the S&P 1500, in 2011 84% lagged behind the market, and in 2012 66% did worse than the averages.

For this three year period, each of the thirteen mutual fund categories tracked by S&P, on average posted returns worse than their respective benchmarks.  During this period, only Large Cap Value mutual funds beat their benchmark once — in 2010 when 65% of this class of funds exceeded the S&P 500 Value Index.  Unfortunately, in 2012 Large Cap Value funds gave back most of their outperformance when 85% of these funds underperformed their benchmark.

According to a recent article published by Bloomberg Business Week, Bank of America Corp. strategist Savita Subramanian recently calculated that the number of mutual funds which have outperformed their respective indices during the first ten months of 2014 was a mere 18% — the lowest success rate in 10 years.


Buy-Side Excuses Proliferate

Of course, most investment managers have come up with numerous excuses for why their mutual funds have under-performed the market in 2014 for anyone who will listen.  The Bloomberg article highlights a few of these excuses.

Some managers argue that their underperformance was based primarily on the fact that they did not invest in one or two stocks, including Apple or Microsoft.  Apple rose 41% in 2014 while Microsoft rallied 33% during the year – counting for a significant portion of the S&P 500’s 30% rally.

Other managers contend that the Federal Reserve continued monetary easing led to tighter correlations and less dispersion between different industry groups, making it difficult to identify potential outperformers as all sectors were propelled higher.  Some argue that the boom in ETFs have created a similar circumstance.


Some Changes in the Offing

However, this rather difficult market for stock-pickers could be about to change says the Bloomberg article.  In a recent report titled, ‘‘Era of Active Investing Upon Us,” BMO Capital Markets chief investment strategist Brian Belski concluded that intra-stock correlations, or the tendency of stocks to rise or fall together, have dropped in recent months and are now at below-average levels after being above average for many years.

Tom Lee of FundStrat Global Advisors also argues that the narrow dispersion of returns among industry groups seen in recent years is actually cyclical and that this dispersion is likely to revert back to the long-term average – a development which would provide a boost to the performance of actively managed funds.


Consequences for Research Industry

If these analysts are right, then investment managers who are skilled at stock-picking should be rewarded.  The good news for participants in the research industry is that research that can help investors accurately identify winners and losers could have a greater impact on the alpha of their funds, thereby making this type of research more valuable.

In our minds, this could be a boon for fundamental sector specialists, short ideas providers, and other investment research providers that have deep industry expertise or a good track record providing specific long or short stock recommendations.  Clearly this would be a welcome development after the last few years where many buy-side firms have trimmed their expenditures on sell-side and independent research.

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MiFID II Will Not Ban Research Commissions

November 12th, 2014

According to an article the Financial Times, European legislators have decided not to ban the use of client commissions for the payment of research, as proposed by UK regulators.  During a presentation at a Financial Times event in London, a member of the European parliament said that the priority for European regulation should be commission disclosure not a ban on research commissions.

Kay Swinburne, the Member of the European Parliament (MEP) representing Wales, participates in the Committee on Economic and Monetary Affairs, which is involved in new financial regulation under MiFID II.

The FT quoted her as saying that a ban on paying for research through client commissions was off the table:  “The banning of dealing commissions was discussed in meetings and there was a clear decision taken to not ban the use of commissions,” adding “MEPs have subsequently made it very clear to ESMA [the European Securities and Market Authority] that disclosure of the use of commissions is sufficient and banning of commissions should be off the table.”

It is telling that a MEP representing the UK is opposed to regulation proposed by the UK Financial Conduct Authority (FCA).  Ms. Swinburne is Conservative co-ordinator for Economic and Monetary Affairs, having been elected to the European parliament after a career in investment banking.

Frustrated by its perception of a lack of industry progress on commission transparency, the FCA proposed a ban on research commissions in July, igniting a firestorm of opposition.  The FCA had hoped that the ban would be incorporated in pending European regulation under MiFID II.  However, its stance mobilized protests from a wide variety of industry participants, including asset managers, investment banks and independent research providers and their respective trade associations.

An influential advisory group to European securities regulators attacked the proposal and senior French regulators went public with their opposition to a ban.

Even though MiFID II regulation will now likely not ban payment for research with client commissions, there is nothing to prevent the FCA from taking a stricter stance.  As Ms. Swinburne noted, “The FCA, however, has the flexibility to go further under investor protection if they choose to do so, and we need to make sure they do not deviate too far away from the ESMA rules.”   She argued that separating costs could hurt the research market and efforts to bring companies to the market, concerns similar to those voiced by French regulators.

However, the FCA does not need to implement new regulation to shake up the industry.  The new guidelines it implemented in June are doing that already, as we have noted.  The new regulation banned the payment for corporate access with client commissions, required more rigorous valuation of bundled research, and prohibits payment for research which is not utilized.

As we predicted two months ago, MiFID II will not ban research commissions.  However, that does not mean the industry does not face significant reform.  European regulators seem disposed to use MiFID II to prod the industry for more commission transparency.  CSAs are well positioned to benefit.

We also suspect that European regulators will go even further toward replicating the current FCA rules, whether or not explicit language is incorporated in the MiFID II rules.  European regulators may not have the FCA’s detailed understanding of research commissions, but they can grasp the concept that research payments should not increase just because trading volumes increase.  It is even possible that the SEC might make a token effort in the interest of regulatory harmony.

While the industry might breathe a sigh of relief at averting a ban on research commissions, the prospect of broad regulatory acceptance of the new FCA regime will be more than sufficient to ensure major changes in the research landscape.

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Wall Street Layoffs Jump While Hiring Stalls in October

November 10th, 2014

Layoffs at Wall Street investment banks and brokerage surged in October to the highest level seen since April, 2014, according to a recent private jobs report.  In addition to the pickup in layoffs, new hiring during October also stalled as Wall Street firms refuse to expand their payrolls in an environment where equity commission volumes remain weak, interest rates are edging higher, and regulatory changes are looming on the horizon.


October Challenger, Gray & Christmas Report

According to the Challenger, Gray & Christmas monthly Job Cuts Report released recently, the financial services industry saw a 183% surge in planned layoffs from 591 layoffs announced in September to 1,673 layoffs announced in October.  The only good news in October was the fact that this year’s level of announced layoffs was 80% lower than the number of layoffs announced in October of the previous year.

On a year-to-date basis, Wall Street firms have announced 26,296 layoffs during the first ten months of 2014, 54% less than the 57,591 layoffs announced during the same period in 2013.  The decline in announced layoffs on a year-to-date basis is a signal that the employment outlook is on the mend – albeit only modestly.

However, no one should take this data as evidence that the Wall Street employment picture is rosy.  For the second consecutive month, financial services firms failed to announce any new hiring during October.  This marks the fourth month this year where no new hiring has been announced – a clear sign of caution on the part of Wall Street executives.  On a year-to-date basis Wall Street firms have announced plans to hire 2,729 new positions, 32% lower than the 4,011 new positions announced during the first ten months of 2013.


Banks Shed Workers to Hit Profit Targets

As we have mentioned in the past, the Wall Street employment picture, while getting better is not indicative of an industry on the upswing.  In fact, we expect many investment banks will continue to shed workers and keep a lid on new hiring through the end of the year in an effort to hit their profit targets.

Last month Citibank announced plans to lay off 370 employees in the company’s consumer banking business in the Des Moines area by the middle of next year.  Management explained that this decision came from “ongoing efforts” to increase efficiency of its operations.

In addition, Bank of America announced that it was planning to lay off over 260 employees in Addison and Plano Texas.  Some of these employees worked at BofA’s Legacy Asset Servicing unit.   Since mid-2013, the bank has laid off more than 900 workers in the region.


Impact for the Research Industry

Given these conditions, we very much doubt that either Wall Street investment banks or independent research firms will alter their cautious approach toward hiring staff in their research departments over the coming few months.  Not only are public companies looking to meet year-end profit targets, but many sell-side and independent research providers are nervous about the impact that the recent FCA and ESMA announcements about eliminating the use of client commissions to pay for corporate access, and the possible ban in using commissions to pay for any investment research might have on their businesses.

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The Pros & Cons of Outsourcing Research Sales

November 5th, 2014

Financial Research Solutions, a research sales firm, has released a new white paper examining the advantages and disadvantages of outsourcing the research sales function.

Financial Research Solutions is an outsourced sales firm founded by Will Richards, who was a successful salesperson for BCA Research during its hyper-growth period.  FRS currently has six in-house sales professionals.

Outsourcing sales

Outsourced sales firms typically work on a success-fee basis, which means they are paid when they make sales.  The obvious benefit to research firms is that this limits their downside, but it also means that the sales firms are selective in the research they agree to sell.

Partly this reflects the upfront investment that an outsourced sales firm makes when establishing a new relationship.  To effectively sell, it is important to understand the research which requires time and effort.  Also, outsourced sales firms frequently do more than just sell.  They often conduct marketing campaigns, handle invoicing & accounts receivable, and may even provide product fulfillment.

Economics

Because outsourced sales firms work on a success-fee basis, they incur expense before they see any revenue.  For this reason, most operate on a revenue-share basis, taking a percentage of revenue received from new clients they help bring in.  Because the outsourced sales firm is also involved in retaining the clients it brings in, the revenue share will usually continue for as long as the client stays with the research firm.

The revenue share for an outsourced sales firm is usually higher than the commissions a research firm would pay an in-house salesperson.  However, outsourced sales firms usually take on more than sales management, including marketing campaigns, mailings, and other lead generating activities.

Good salespeople easily command six figure compensation while sales and marketing infrastructure — such as a CRM system, prospect databases, travel costs — can be high five figures to low six figures.  For research firms with limited capital, outsourcing may be a better route than an inadequate internal effort or none at all.

Pros & Cons

The main benefit of outsourcing the sales function is to grow revenues without a major investment in in-house sales and marketing.  For research firms which have limited appetite or experience in managing salespeople, outsourced sales are generally a lower risk proposition than hiring and managing salespeople.  If the outsourced sales firm is not successful, there is no or limited payment whereas an unsuccessful salesperson is generally paid regardless.

The biggest sticking point for research firms is typically the revenue share, particularly the fact that the revenue share continues for the length of the client relationship.  Although partly an incentive to help retain clients, the revenue tail also reflects a payback to the outsourced sales firm for its initial investment in the relationship with the research firm.

However, the biggest issue with outsourced sales is that it requires a significant investment of time to be successful.  While less demanding than managing in-house sales, there still must be a commitment on the part of senior management and analytic staff.

Managing the relationship

Although outsourcing sales is less demanding than managing an in-house sales force, to be successful it requires proactive engagement from the research firm.  This is not just a function of time spent helping to close new business.  There is the initial product training required to make the outsourced sales firm effective in representing the research product.  It is also recognizing that the outsource sales firm brings insights into what clients like and don’t like that can yield improvements in how the research is generated or delivered.

Most importantly, although outsourced sales firms can bring a level of professionalism and sales management that is difficult to replicate internally, they are ultimately sales animals themselves.  This means it is important not only to listen and learn from them, but to seek ways to keep them excited and motivated about your research product.

The full 6-page FRS white paper includes more detail and additional topics such as when to outsource and how to evaluate an outsourced sales firm, and can be viewed at www.FinancialResearchSolutions.com/downloads/white-paper.pdf.  Additional questions can be directed to author Will Richards at 514.849.1991 or will@FinancialResearchSolutions.com.

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Three Insider-Trading Probes Focus on Possible CMS Leaks

November 3rd, 2014

The SEC is currently investigating three separate insider trading cases which focus on whether the Centers for Medicare and Medicaid Services (CMS) leaked confidential information to boutique policy research firms who passed on this information to hedge fund clients, prompting significant price swings in health care stocks.


CMS & Marwood Group

The first case that the SEC is looking into is whether employees at CMS leaked information to policy research firm Marwood Group LLC about CMS’s pending review of Dendreon Corp’s prostate cancer treatment called Provenge.

Despite the fact that Provenge costs approximately $93,000 per person, the government is obligated to cover this drug for Medicare patients.  However, CMS has the authority to set coverage limits in situations where it feels the benefits of the treatment are unclear.

The reason for the SEC’s investigation is Dendreon’s stock price fell 10% on June 7, 2010 shortly after CMS officials decided to review whether coverage limits should be applied to Provenge.  Over the course of June 2010, Dendreon’s share price fell more than 26%.

Federal investigators are looking into whether officials at policy research firm Marwood Group contacted hedge fund clients with confidential information they obtained about CMS’s decision to review Provenge coverage.  The SEC is also supposedly examining whether Marwood Group obtained inside information from CMS employees in other instances.

A spokesman from Marwood said the firm “has cooperated fully with the SEC’s inquiry and demonstrated to the SEC that we knew nothing about the CMS announcement on Provenge beforehand, and that we were completely surprised by it.”


CMS & Blaszczak

The second SEC investigation is focused on whether highly respected health-care policy analyst and former CMS employee, David Blaszczak, received tips from other CMS staffers on a number of developments related to Medicare.

In 2006, Mr. Blaszczak, who left CMS the previous year, issued a report correctly predicting steep cuts in hospital-reimbursement rates for some procedures involving medical-device companies.

On June 29, 2010, while working for independent policy research firm Potomac Research Group, Mr. Blaszczak issued a research note predicting that CMS would likely review its coverage limits for Dendreon’s Provenge.   The company’s shares sank nearly 10% that day, closing at $33.59 on unusually high volume.  CMS issued its formal “National Coverage Determinations” (NCD) notice publically indicating it would review Provenge coverage limits on the following day – June 30th, 2010.

Mr. Blaszczak, who has since left Potomac to set up his own research boutique, explained the accuracy of his research calls recently in a written statement, “I only use public information in preparing all my reports.  I am proud of my record, and if needed, will vigorously fight any false allegation.”


CMS & Height Securities

The SEC is simultaneously investigating whether CMS employees leaked material non-public information concerning an April 1, 2013 announcement of Medicare reimbursement rates to boutique policy research firm Height Securities before the official CMS announcement and whether any of their hedge fund clients traded on this information.

Less than an hour before CMS released its formal announcement on April 1st, Height Securities sent out an email alert to more than 150 buy-side clients predicting that CMS would turn a suggested 2.2 percent cut for Medicare Advantage providers in 2014 into a 3.3 percent pay increase. After markets closed CMS issued a press release confirming the pay cut reversal, which prompted the SEC to investigate whether the alert issued by Height Securities violated securities regulations and whether anyone broke insider-trading rules by leaking CMS’ decision.


Impact for Research Industry

Clearly, with the three cases currently being investigated, the SEC is trying to put increased pressure on government agencies, lobbyists, boutique research firms and their hedge fund clients about the handling of material nonpublic information obtained from government insiders.

In our view, the SEC is trying to use these cases to establish a legal precedent based on the 2012 STOCK Act that insider trading can be charged if federal agency employees, lawmakers, or their staff discloses confidential nonpublic information about government matters that could move stock prices.

While we suspect the SEC will have difficulties proving these cases for a variety of reasons, we would not be surprised if buy-side investors became increasingly nervous about using potentially risky “political intelligence” like the information discussed in the three cases mentioned above for fear of having their funds included in a front-page article in the Wall Street Journal or Washington Post about a pending government investigation.

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Capital Economics Sells Stake Valuing Business at £70 million

October 29th, 2014

Capital Economics, Ltd., a London-based economics research firm, received a capital infusion valuing the firm at £70 million (US$112 million) which is significantly above the original asking price of £50 million.  Although Capital Economics has not yet released its 2014 financials, the valuation seems to reflect the high profitability of its business.

LDC, the middle market private equity arm of Lloyds Banking Group, is purchasing a minority stake for an undisclosed sum which values the firm at £70m.  As we reported in August 2013, Capital Economics had reportedly hired Quayle Munro to put the firm up for a sale with an asking price of £50 million.  The sale attracted 25 potential bidders.

Capital Economics plans to use the proceeds to hire more staff at its overseas offices in Toronto and Singapore, and is considering opening an office in Australia.

Capital Economics was founded in 1999 by Roger Bootle, a former HSBC chief economist.  The company’s macroeconomic research covers developed and emerging markets, and the firm reportedly has 1,500 firms subscribing to its research.   Bootle owned 68% of the firm prior to LDC’s investment.

For the fiscal year ending April 30th 2013, Capital Economics had revenues of £15 million (US$22.5 million) and a profit after tax of £4.6 million (US$7.5 million), representing a juicy margin of over 30%.  Revenues were up nearly 13% from the previous year’s £13.3 million.

We suspect that the valuation is founded on an EBITDA multiple rather than a revenue multiple, reflecting the high profitability of Capital Economics’ business.  The firm’s 2013 pre-tax profits were £6 million ($9m), which represents an 11.7x multiple on 2013 EBITDA.

By comparison, Euromoney’s US$112 million base purchase price of Ned Davis Research in 2011 was approximately 10 times NDR’s 2010 pre-tax profits.  The maximum purchase price with earn-outs over the succeeding two years was $173 million, representing an EBITDA multiple close to 15x.  The amount actually paid by Euromoney was likely somewhere in the range of an EBITDA multiple of 12x, comparable to Capital Economics’ valuation.

The challenge for Capital Economics will be to maintain its high margins as it adds more staff and expands its business internationally.  Presumably many of the new hires will be salespeople.

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Small Cap Research Firm Sidoti Files for IPO

October 27th, 2014

New York based small cap focused research firm, Sidoti & Company, Inc. recently filed to raise up to $35 million in an initial public offering.  The IPO will be co-managed by WR Hambrecht & Co. along with Sidoti’s own investment banking arm.

Terms of the Offering

Last Thursday, Sidoti filed a Form S-1 Registration Statement with the SEC to raise up to $35 million in an initial public offering.

According to the filing, Sidoti generated $30.3 million in revenue in 2013, compared to $29.8 million in 2012, and net income of $800,000 for both years.  For the first six months of 2014, Sidoti recorded $14.1 million in revenue and $300,000 in net income.

While terms of the proposed offer were not provided, we estimate that Sidoti will sell between 50% to 60% of the firm to the public if the offering is fully subscribed.

One interesting aspect of the offering is that Sidoti & Company’s own investment banking division will be running the IPO alongside WR Hambrecht & Co.

Background on Sidoti

Founded in 1999, Sidoti & Co. is a boutique research firm that produces and markets US small and micro-cap research to long only asset managers and hedge funds.  The firm serves almost 500 institutional investor clients in the United States, Canada and the United Kingdom.

As part of this research offering, Sidoti provides research reports, institutional sales coverage, access to corporate management, and it allows buy-side clients to pay for its research via its trading desk.  In recent years, the firm has started offering limited investment banking services.

Asset management clients have told us that the principal strength of Sidoti’s research services has been the knowledge that the firm’s analysts have of the companies they cover, the relationships they have had with company management, and the corporate access events they have offered.  In addition, clients have also valued the fact that Sidoti analysts produce models for all the companies they cover.

In the past few years, Sidoti expanded its business from providing research coverage primarily on companies with a market cap of between $300 mln to $2.0 billion (small cap companies), to micro-cap companies (companies with a market capitalization of less than $300 million).

Rationale for the IPO

Sidoti’s planned IPO is based on a couple of factors.  First, Sidoti’s core business, producing and selling small cap research to the asset management community, has flattened out in recent years.  Equity commissions – the currency used to pay for equity research – have fallen over the last few years creating a difficult environment for growth.  In addition, many long only asset managers have continued to cut costs in recent years as they have lost market share to ETFs, index funds, and other low cost investment products.

Ultimately, these trends have led Sidoti management to look to expand into other businesses which might be able to pick up the slack for flattening research sales.  One obvious direction is to leverage their small and micro-cap research expertise to manage money themselves.  Management highlighted this rationale in their S-1.

“We intend to leverage our established small- and micro-cap research brand to expand into the asset management business.  We believe a unique opportunity exists to establish an asset management platform focused on the small- and micro-cap segments. We believe these segments are underserved by existing asset managers and that significant capacity exists to create such a platform. As we establish a track record of performance in this business, we intend to expand our reach and seek to attract assets from other institutions, high-net-worth individuals and other sources.”

Another reason we think Sidoti management decided to go public at this time is to help the firm attract top flight analytical, sales and money management talent. Sidoti has historically been known as a firm that refuses to overpay for talent.  As a public firm, Sidoti will have the luxury of attracting qualified staff with equity, as well as cash compensation.  We think this will be important to the firm as it tries to build out its asset management business, as well as hire high quality research analysts.  Management explained this in their recent filing.

“We expect that our transition to a public company will enhance our ability to execute our growth strategies and meet our clients’ needs. As a public company, we expect to have greater visibility with clients, increased access to capital, and additional currency to explore strategic opportunities. Operating as a public company should also enhance our ability to attract and retain high-quality professionals by expanding our effort to offer equity-based incentives linked directly to the success of the business.”

Lessons for the Research Industry

The Sidoti IPO is the latest chapter for a research provider which has continually evolved.  Originally an independent research firm, Sidoti added a trading desk early on in its existence in an effort to maintain some control over the amount of commission revenue buy-side clients were directing to the firm to pay for its research.  Before setting up its own desk, Sidoti partnered with another broker-dealer for commission payments.

In the past few years, Sidoti added an investment banking arm in an effort to bolster its revenues as it decided to leverage its research capacity by partnering with other banks that did not have this capability to win small cap banking mandates.

Now the move into asset management.  Clearly, Sidoti is not the first independent research firm that has decided to go into the asset management business (Argus Research, Thomas White International, and Ned Davis Research are just a few examples).  Unfortunately, many other research firms have struggled with making the transition from purely producing and selling research to gathering sufficient assets to create a profitable asset management business.

Maybe this is why Sidoti decided to raise capital in the public market in order to hire the talent required to raise capital, as well as hire money management professionals who have built up an attractive track record.  It will be interesting to see how Sidoti’s IPO fares, and how successful the business is in building its asset management division.

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French Regulators Go Public Opposing a Research Ban

October 22nd, 2014

French regulators have gone on the record in their opposition to a ban on paying for research with client commissions, as proposed by the European Securities and Markets Authority (ESMA), the European-wide regulatory authority charged with codifying the MiFID II regulatory language.  The explicit stance by senior French regulators is a strong indication of the depth of their opposition, but it also may signal that opponents are looking to rally support for modifying the draft language.

The influential financial publication, L’Agefi, published an interview on the topic with Benoît de Juvigny, secretary general of the L’Autorité des Marchés Financiers (AMF).  De Juvigny expressed concern that the volume of research would be greatly reduced if asset managers had to pay for it out of their own pockets, and that this would have a negative impact on markets.

He envisions a retrenchment in the number of research providers, with only a small number of brokers offering research:  “We fear a drastic reduction in the funds allocated to research and the result would be a small oligopoly of brokers following only large cap French companies, and that there would be less and less, or more no analyst on small and mid-cap stocks.”

As we have noted, the AMF has previously aired concerns about the impact of a ban on French asset manager profit margins, and that smaller asset managers would be less able to afford research than larger managers, putting them at a competitive disadvantage.

De Juvigny questioned the legitimacy of the proposed ESMA language, saying that reforming investment research was never intended as part of MiFID II.  He seemed to favor striking the language banning payment for research with client commissions and proposing instead a study of potential reform.  He also indicated that any reform should be done on a global basis otherwise European asset managers would be at a disadvantage relative to those in other domiciles.

Our take

It is impressive that the number two regulator at the AMF would come out so vehemently opposed to the proposed ban on research commissions.  It confirms what we have heard from numerous sources about the disquiet felt by French and German regulators over a ban.

However, it makes us wonder why the AMF would choose to go public now, long after the public comment period on the proposed language has been closed.  Did he feel the need to counter the UK Financial Conduct Authority (FCA) 59-page discussion paper supporting a ban?  Was he enlisting support from fellow regulators in voting down the ban?

Based on the broad opposition to a ban, the large volume and diversity of negative comment letters on the draft language, and the opposition from influential regulators on the continent (now going public), we have greatly discounted the probability of ESMA going forward with a ban.  On the face of it the interview in L’Agefi seems to support that view, but it does raise the question of whether there might be more regulatory support for the FCA-sponsored ban than is readily apparent.

For those who are French-impaired here is a crude translation of the interview with Benoît de Juvigny:

ESMA is proposing that asset managers pay for research out of their own pockets rather than with client commissions.  What are the AMF’s thoughts?

The AMF is concerned. The language in ESMA discussed by regulators is completely at odds with everybody else.  For the AMF, investment research is something extremely important. We fear a drastic reduction in the funds allocated to research and the result would be a small oligopoly of brokers following only large cap French companies, and that there would be less and less, or more no analyst on small and mid-cap stocks.  It would make it difficult for SMEs to get financing.  This reform could greatly reduce the amount of research available in the market.

What alternatives do you favor?

We do not advocate a particular solution at this stage, because we believe that the very principle of this reform in the context of MiFID II is questionable. It is a subject that was not really discussed at the political level. MiFID II is a text on investment services, is not a text on asset management, more importantly, it deals only with discretionary mandates and not with collective management. It seems to us that such a reform would first require serious study.  I am not sure that everyone has thought through the potential consequences to the market. Finally, for us, such an initiative should come in a more international setting.   European regulation will have a higher cost to European funds than to non-European funds.

Advocates of reform cite the risk of abuse in the pricing of research…

They raise good issues because the current system is far from perfect.   The current regime risks some inflation in research costs through excesses around corporate access or how the costs are allocated among clients or the risk of overspending through brokerage commissions.  Regulation has begun to address some of these issues. I do not say that it should not go further. But do we need to go to the extreme of revolutionizing the funding of research, risking a drastic reduction in the amount of research?

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Improving Your Golf Game and Curing Underperformance

October 20th, 2014

Readers of this blog know full well that the investment research business has been impacted by a number of factors over the past decade which has pressured the active management business.  One of the most obvious issues (though one that is often not discussed) is the consistent underperformance of the investment management industry.  Unfortunately, few ever discuss how buy-side investors might improve their investment performance.  The following article starts an important discussion on this topic.


The Problem

More than 80% of actively managed funds underperform each year, and it has been this way for decades. In response several trillion dollars of capital has been reallocated away from active management and into passive products like index funds and ETFs with no end to this trend in sight. If this weren’t enough, fees for active management are continuing to drop like a rock. All told, the future for active management is very challenging especially if the current dynamics continue.

And that’s where a new book called “Managing Equity Portfolios: A Behavioral Approach to Improving Skills and Investment Processes” by industry veteran Michael Ervolini offers hope to the industry. Recently published by MIT Press, Mike’s book challenges active equity managers to improve their performance before it is too late and then provides practical ideas for how to begin improving their skills using an intuitive but rigorous method he lays out in a straightforward style.

Michael Ervolini has over 27 years of experience in institutional investment management and software development.  Prior to co-founding behavioral finance firm Cabot Research, Mike was a founder and CEO of Charter Research Corporation. Previously Mike was a Portfolio Manager and Chief Information Officer with AEW Capital Management where he first started using information technology as a strategic tool to run institutional portfolios. He was also a Vice President with Legg Mason Real Estate Institutional Advisors (Philadelphia, PA). Mike holds a B.A. in economics from Rutgers University and an M.S. from the University of Pennsylvania.


How To Start Solving The Issue…

The following quotes from Mike’s new book get to the heart of how asset managers might be able to start identifying and practicing the skills they need to improve their performance.

“One reason that so many equity managers can’t improve is poor feedback. Here is what I mean. Traditional portfolio analytics like relative return, information ratios, alpha hit rates and attribution are useful to a point  … but what they all share in common is that they are merely scorecards.  They measure how the manager did over a period of time and that’s it. They say nothing directly about skill and that is a huge problem. It is as if a golfer is only told the scores of her games and had no idea of where she had the most skill: Is it her drives off the tee? Her irons in the fairway? Or her putts? Armed with only the scores she would have no chance of becoming self aware or improving. This is precisely the bind that equity managers are in today. It’s why they can’t improve.”

Mr. Ervolini continues his explanation, “For example, all managers should know whether they generate more excess return from their buying or their selling. But they don’t. They have a gut feel or an intuition but they really don’t know. And not knowing your personal strengths and shortcomings makes it impossible to improve. I have this very conversation regularly with managers around the globe and they all agree that they would like to improve but they are not sure of which of their skills are strongest and which need retooling.”

Mike expands on his golfing analogy, saying “Unlike portfolio managers, golfers benefit from rigorous and granular feedback about their skills and sub-skills. It is the quality of the feedback that enables them to improve even when they are at the pinnacle of their ability. My book provides a new analytic framework that enables equity managers and analysts to get on par with golfers when it comes to feedback. Each page contains practical information for becoming more self aware and a better investor. The book describes a new analytic framework that enables professional investors to quantify how much skill they have at buying, selling and sizing positions. The book also shows how to use this information to improve deliberately. Hundreds of managers and analysts are using these techniques today and they are seeing terrific results. Put simply, if you want to survive as an equity manager you need to do better and my book offers you the roadmap to stronger skills, investment processes and eliminating behavioral tendencies.”


Two Key Findings

The following summarizes a few of the key findings of the research that Mr. Ervolini lays out in his new book.   “I’ll end on this note. At Cabot we’ve analyzed hundreds of professionally managed equity portfolios and here are just two of our findings. First, virtually all managers, even those that have been above their benchmarks for years, have at least one skill that is negative and it is draining performance from the portfolio. Second, over eighty-five percent of managers exhibit at least one behavioral tendency that is very persistent and costs the portfolio in excess of 100 bps of return year-after-year. The question then is: What behaviors are hurting your performance and isn’t it time to find out?”

Mike’s book and the need to help active management are the topics of an event being hosted by Bloomberg LP on Tuesday, November 11, 2014 starting at 4:00 PM, in NYC. Contact information@cabotresearch.com if you’d like to attend this industry-wide conversation about the future of the asset management business.  You can learn more about Mike’s new book, and purchase it directly by clicking on the following link  http://amzn.to/1yPscbL.

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Conference on Broker Voting

October 17th, 2014

The Wall Street Transcript (TWST), the venerable publication of CEO and analyst interviews, will be hosting a Broker Vote Summit on October 22nd at The Harvard Club in New York City.  The conference is well timed in light of regulatory pressure to increase transparency on research pricing and valuation.  Readers of our blog are being offered a 15% discount on the registration fee.

The  conference is being organized by TWST Events and features the Wall Street Transcript’s subsidiary MeetMax, which offers software to facilitate conferences and road shows.  MeetMax also has a broker vote service.

The Broker Vote Summit will include buy side and sell side panels, as well as 1:1 meetings (using MeetMax’s conference software, naturally) and vendor workshops.  Vendors of broker vote solutions, including Markit, Extel and State Street Global Markets as well as the host firm, will be in attendance.  The key note speaker is David Maber, a professor at the University of Michigan who has authored a study on broker voting.  The conference agenda can be found at  http://brokervotesummit.com/.

Increasing regulatory scrutiny in the UK and Europe of research payments and pricing is bringing broker voting into the spotlight.  Broker voting helps to increase transparency, and will most likely evolve further as a result of regulatory reform.

Readers of our blog are being offered a 15% discount on the $495 registration fee.   To register for the conference go to

https://meetmax.com/sched/event_27828/investor_reg_new.html?register=cmd&event_id=27828&attendee_role_id=ATTENDEE

To obtain the 15% discount, submit the code “INTEGRITY” (all caps) when asked for a discount coupon.

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