Equity Analysts Threatened by Quants? You’re Missing the Point

Reuters ran a story today titled Equity analysts facing new quant challenge, that is squarely at the intersection of two “buzzy” themes: (1) the death of sell-side analysts; and (2) the rising prominence of the quant trader. This story, both in its title and in its body, purports to link these two themes, implying that the rise of model-driven trading poses a direct threat to the sell-side analyst community. Now, I’ve done my bashing of sell-side analysts before, and I’m not about to change my stripes, but I do think that the story is mixing up correlation with causality and drawing conclusions based on artifact rather than substance (which is kind of funny for a story on quant trading). IMHO, analysts are not at risk of being replaced by machines, both given the limitations of model-driven trading (which the article really doesn’t point out) and the vast number of ways to make money that are not purely formulaic. But this statement is dependent upon one key fact: the analysts have to be really good. And herein lies the rub.

For my money, Brad Hintz at AllianceBernstein made the most accurate and defining statement as to why sell-side research is in trouble:   

The biggest, he said, is declining trading commission rates at major
Wall Street firms, which has forced them to cut costs and outsource
research. Regulatory investigations into analyst conflicts, the
technology stock crash and other factors also played a part.

Still, the commission revenue decline has caused major investment
banks to boost resources to higher-margin quantitative trading and
derivatives desks, further fueling the trend.

“There are lots of arguments as to why equity analysts are doomed,” said Hintz.

Indeed. I would add to Brad’s statement, also including the de-coupling of the costs of research and execution, the transparency of which lays bare the real cost of delivering the sell-side research product to buy-side clients. And if the research added lots of value and were worth the money, the buy side would pay for it. Problem is, much of the time it is not adding lots of value and is not competitive in either cost or quality with a well-armed buy-side analyst who is paid for performance and not for commissions and investment banking revenues generated (I know sell-side analysts aren’t supposed to be paid for investment banking business, but come on, folks. This is the real world). And this is just the sad truth. And this is why sell-side research departments have gotten mercilessly slashed in the name of - yes - profits. Smart and predictable behavior on the part of Wall Street leadership.

Is quant trading great? Yes, if built and managed well. Is it a rising trend? Sure. But is it the catalyst for the death of the sell-side analyst. No way. It’s a cost-benefit issue, pure and simple. The sell-side analyst, in general, is just not worth it. If it were, buy-side firms would be willing to pay for it in a clear and transparent manner. There is a clear alignment of motives: if sell-side research and ideas are good and make me money, why wouldn’t I pay for it? Of course I would. This is the way it works with buy-side analysts - pay for performance. So why not external analysts? Because they’re just not as good. And this is the REAL problem Wall Street has to solve if they want to remain in the research business, long term. Otherwise, just throw in the towel and get on with it. Being half in/half out isn’t good for anybody. Not good for the analysts and certainly not good for the shareholders.

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COMMENT:

AUTHOR: haaha

EMAIL: ahhah@ahaha.com

URL: 

DATE: 06/03/2007 09:09:18 AM

no comments?  where is yawser anwar 

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COMMENT:

AUTHOR: Irvin

EMAIL: frozen.waste@gmail.com

URL: 

DATE: 06/03/2007 10:13:22 AM

I’m admittedly a bit young, so my perspective of sell-side analysts may be somewhat lacking.  But my view is that the shifting economics of sell-side research (i.e. falling commissions, increasing demand for transparency, etc.) are just the hair breaking the camel’s back.    Admittedly, it’s a very large hair, but the point still remains.

The real damage, in my estimation, comes from changes in the way that sell side analysts do their work.  With Reg FD shutting down selective disclosure, the global settlement rebuilding the Chinese walls between analysis and banking, and the internet equalizing access to investor information and other data sources, the actual value of the sell-side analyst has been greatly diminished.  They can’t give you inside information anymore and their ratings can’t technically be used as an incentive to draw in banking deals.

By now, all of this is pretty old news.  But I think it’s important - the reason that sell-side analysts are in decline is *not* that the economics of the industry have changed.   It’s because their competitive advantage / value has eroded, ultimately bringing down the industry’s willingness to pay for their services.  I’m sure that if sell-side analysts could produce research that was head and shoulders above what any in-house analysts could do, the banks could easily find a way to continue monetizing their researchers.

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3 years ago | view comments |  Wall Street