Are analysts and fund managers too friendly?
It’s hard to think of an industry more ripe for reform than active fund management. As data from the likes of Morningstar (1) and S&P Dow Jones (2) show us time and again, active management extracts value for consumers.
Yet here is a community that is characterised by inertia. It’s driven not, as industries are supposed to be, by a ceaseless quest for dynamism and innovation, but by habit, routine and outmoded ideas.
The question then is why fund management is so stuck in its ways. There are several reasons for it — not least the fact that, despite the growing threat of low-cost index funds, profit margins remain high. Let’s face it, if you run a fund management company, why would you want to disrupt a business model that’s still so lucrative?
But another explanation for inertia that is often overlooked lies in the social connections underpinning active management. Financial professionals, like all of us, are social beings. They naturally prefer to work with people they like and share outside interests with. Fund management companies have large hospitality budgets for entertaining financial advisers, investment consultants and journalists.
Another key relationship is the one between fund managers and sell-side equity analysts. These analysts play an important part in the process of investment decision-making, providing fund managers with information and advice, such as earnings forecasts, buy and sell recommendations and target prices.
A new study shows how close the interpersonal bonds between fund managers and analysts can be, and how those ties could well be at odds with good consumer outcomes and the need for reform. (3)
The researchers — Yuval Millo, Crawford Spence and James Valentine — interviewed 70 people working in fund management and equity research in London, New York and Chicago. What they discovered was that professional relations in the field of investment advice are embedded in social ties that steadily grow and span entire careers.
These relationships tend to be very “sticky”, the authors found. It takes effort to build new relationships and people have limited time or inclination to do so if nobody is forcing them to.
Fund managers, the paper says, “are often reluctant to replace their sell-side analysts, even when the economic case for doing so might be strong.” In other words, these personal ties support and protect the role of sell-side analysts — and to some extent irrespective of whether they provide useful information to investors.”
Several of the fund managers interviewed admitted hiring their friends and then being reluctant to cut them loose, even if they are not performing.
“Dinners, games, free lunches, nice guy, he’s got a family — there’s all that shit that I think keeps people around,” one Chicago-based fund manager told the researchers. “I think it’s not even corruption. It’s just reality. We hire people that we like. A lot.”
What’s in it for fund managers?
Analysts, then, have a vested interest in keeping these social ties strong. But why do fund managers continue to employ analysts even when they are dubious about the value of their research? What’s in it for them?
Millo, Spence and Valentine stress in their conclusion that it’s not because fund managers are lazy that they persist with underperforming analysts. It’s a result, they say, of what economists call path dependency — in other words, they do so because they always have done, and changing the way they do things is considered too much trouble. (4)
“This social inertia,” the authors claim, “is also supported by the notion that the sell-side’s main role is not necessarily to provide information or investment insights, but to generate investment banking business opportunities.”
This explains the rather perverse scenario whereby equity analysts, to quote one New York fund manager, “could be wrong but still make a ton of money.”
Historically, in fact, fund managers didn’t even pay for research, at least not directly. That’s because the cost of research was bundled together with other services, including stock trading, for which analysts charged large commissions. Ultimately, it wasn’t fund managers but end investors who paid the bill. That prompted the EU to ban the “bundling” of research in 2018.
The ban on bundling had a positive effect for investors because commissions fell and most fund managers opted to absorb the cost of research rather than raise their fees. Now, however, some European countries, including the UK, are considering rowing back on fee bundling and allowing it again — a clear step backwards for cost transparency and, almost certainly, investor outcomes. (5)
In summary, equity analysts and fund managers have developed an almost symbiotic relationship. To an extent, they rely on each other. Both are underperforming and yet the social forces at play mean that both are willing to tolerate that underperformance.
Genuine innovation in active fund management demands a complete rethink of the analyst-fund manager relationship. Fund managers should be the masters, the analyst's servants; they certainly shouldn’t be mates.
Either the research is useful and adds value, in which case it’s worth paying for, or it doesn’t and it isn’t. Expecting consumers to foot the bill for useless research should no longer be tolerated.
This article is produced by us for Financial Advisers who may choose to share it with their clients. Timeline Planning and Timeline Portfolios do not offer direct-to-consumer products
Robin Powell is a journalist, author and editor of The Evidence-Based Investor.