Money Manager Use of Wall Street "Tainted" Research: Do Managers Really Do Their Own Research?
October 2002 Alert
For those of you who love to read fiction and good mysteries, we suggest you curl up one evening this winter with a volume of Nelson Information's Directory of Investment Managers. The massive, three volume 6000-page annual Directory provides comprehensive information regarding 2000 institutional money managers and their 8000 investment products. While the Directory is impressive, the information it provides has one significant flaw: it comes from the mouths of the managers themselves (in response to questionnaires sent them by Nelson's) and is not independently verified. In other words, the firm profiles are more accurately marketing pieces reflecting what firms would like the public to believe about them. The information provided in the Directory should not be relied upon by investors. It can, however, be extremely useful in explaining to investors the realities of the money management business and how investment management firms market themselves. Investors who learn to sift through money manager marketing materials, separating fact from fiction, are far less likely to taken-in by exaggerated representations regarding investment expertise or research capabilities.
The focus of our most recent romp through Nelson's was to examine what firms had to say about their reliance upon Wall Street research. In item 7 of the firm profiles in the Directory, firms state what percent of their research sources are in-house and what percent is "street research." In our experience, all mutual fund advisors and other money managers would like investors to believe they undertake their own depthful research effort prior to investing client funds. Television and print advertisements by investment firms frequently tout a firm's ability to identify tomorrow's leading companies today. Images of analysts and portfolio managers visiting companies by helicopter and pouring through financial statements late into the night are common. The more firms can convince investors they engage in significant value-added research which only savvy investment professionals are capable of undertaking, the more attractive these investment counseling firms are to unskilled investors. After all, if firms simply relied upon Wall Street research, who would need a money manager? But how believable are firm representations regarding their in-house research capabilities? In our experience virtually all claims of depthful, in-house research capabilities are, at a minimum, grossly overstated.
There is a tremendous public debate at this time regarding the conflicts of interest surrounding the investment research written by financial analysts in Wall Street firms with investment banking operations. Public attention is finally being drawn to the fact that this research, (like everything else in the financial world), is often tainted by undisclosed financial interests. Firms that have been issuing fraudulent research in the past few years, misleading investors while they assist their investment banking clients, are finally being held accountable. Money managers seeking to explain less than stellar performances of recent years (or shift the blame) could admit they too have been misled by tainted Wall Street research. But to do so would be to acknowledge they really do little or no research of their own and have been misleading investors regarding their research capabilities all along.
Money managers clearly have a fiduciary duty to investigate before they invest client funds. How depthful such an investigation must be is an open question. Is it enough that the portfolio manager read one or more Wall Street research reports when he should have known (as all Wall Street insiders have long-known) such research is riddled with conflicts of interest? Should the manager have sought out independent third party research? Or should she have conducted her own review?
Some might argue that no investigation or research would have uncovered the complex, deliberate fraud involved in an Enron. So, if the fraud were undetectable, is the manager free of liability for the loss of client funds? Without a causal link between the failure to investigate and the loss, is there no manager liability? We don't know the answers to these questions. However, we do know the answer some related questions.
Do many money managers lead investors to believe they engage in substantial in-house research when they in fact, do not? The answer to this question is undoubtedly, "yes." An examination of the marketing materials of many advisory firms reveals incredible, almost unbelievable, statements of in-house research capabilities. Unfortunately, most of these claims are exaggerations or outright lies. And the performance of firms often suggests their research capabilities may not be as good as they maintain.
Have many investors suffered financial harm by relying upon such statements? Again, the answer is undoubtedly, "yes." Whether having an in-house research capability would have prevented a loss such as Enron or not, is not the question. The question is whether some investors were lured into the stock market by managers who claimed to have a special facility for analyzing its risks-- investors who might not have ventured into equities had it not been for the managers' exaggerated claims.
To date virtually no commentator has focused upon the issue of money manager liability. Most investors who lost money in Enron, Worldcom or other scams did not invest directly in these companies. Rather, they invested in mutual funds or with money managers who put them into these stocks. Professional money managers with inflated representations regarding their investment and research capabilities are to blame for much of the losses. Yet little attention has been paid to the role professional money managers played in the stock bubble that devastated millions.
Getting back to Nelson's, we found that most managers profiled claimed the vast majority of the research they utilize is produced in-house. On average, managers indicated that of their research sources, in-house research amounted to approximately 67%; "street research" amounted to only approximately 26% and "other" represented the remainder.
Firms such as Mellon Capital Management, a subsidiary of Mellon Bank, claim to utilize no Wall Street research. Apparently 100% of their research regarding the developed and emerging equity markets is produced internally by the company's eight equity analysts. While the profile does not indicate exactly how many companies these eight analysts cover globally, they must be a hard working bunch. Mellon Equity Associates, on the other hand, which only uses 2% "street research" claims its six equity analysts regularly cover 3,500 companies. Apparently producing tainted research is far more labor intensive; financial analysts employed by Wall Street investment banking firms could never follow hundreds of companies. (One also has to wonder how many of these "buy-side" analysts have been laid off as a result of declining revenues in the asset management business.)
Janus Capital, a mutual fund money manager suffering from profound performance woes claims they use only 5% street research. Janus says it has 28 equity analysts who regularly follow 500 companies. At about 18 companies per analyst, these lads don't appear to be over-worked; on the other hand, given the firm's performance, they don't appear to be very astute either. The profiles of MacKay Shields and Loomis Sayles both state 10% street research. J.P. Morgan Fleming Asset Management whose 77 equity analysts produce 90% of the firm's research and cover 2000 companies also would appear to be under-worked compared to the analysts at Mellon. Yet somehow Tyco made it past these chaps and shows up as one of the firm's top ten holdings.
The serious point we are trying to make is that carefully scrutinizing investment firms' claims regarding their internal research capabilities can be revealing. As is usually the case when it comes to the money management industry, there is a huge gap between perception and reality. Investors need to ask questions such as:
1. What are the firm's sources of research? 2. How many analysts does the firm employ? 3. How many companies does the firm follow regularly? 4. What are the firm's top ten holdings? 5. What is the cost related to the research effort? Serious due diligence costs money. Does the firm's research budget suggest it really engages in the depth of research its marketing materials indicate?
Investors should even ask to see examples of research produced in-house prior to retaining a manager. When investments sour, investors should ask to see evidence of a serious research effort related to the bad selection. Given the tremendous amount of money investors have already lost and the lack of a meaningful regulatory response, investors should look a lot closer at the investment professionals they employ before they risk losing the remainder of their savings. Finally, remember that virtually all managers exaggerate their research capabilities.
Setting Standards For The Investment Management Industry
