The S&P 500 is up 3.5x since the bottom in March 2009. While this historic bull market has driven portfolio performance, it has occurred amid unprecedented upheaval on both the buy-side and sell-side.
This upheaval represents permanent change in fundamentals for both. It also necessitates a change in how public companies carry out their investor relations strategy and activities.
The Buy-Side Conundrum
Assets under management (AUM) on the buy-side have been steadily shrinking for the past decade. This AUM decline has accelerated in favor of indexing and ETFs over the past few years.
Source: Investment Company Fact Book
The percentage of total U.S. stock fund assets in passive funds has nearly quadrupled since 2000 to 42%. This includes the growth in Exchange-traded funds (ETFs), which have also doubled.
Source: Investment Company Fact Book
Performance and fees are the drivers of this asset shift. While professional fund managers may have the occasional outperforming year, they consistently underperform their benchmarks over the longer term.
Percentage of Equity Managers Underperforming Their Benchmarks
Source: SPIVA Scorecard (2016)
The majority of managers in other asset classes have also underperformed benchmarks over the past 3, 5, and 10 years.
Meanwhile, expense ratios for actively managed funds have declined steadily over the past 20 years. However, expense ratios for passive funds have also declined over that same period. As a result, the fee differential between what investors pay on average for actively managed funds (0.82%) versus index funds (0.09%) is still 9x today.
The shift from active to passive is best explained by cost/benefit analysis. Simply put, investors do not receive sufficient performance from active managers to justify their fees relative to passive investments.
The downloadable 2017 Investment Company Fact Book depicts the whole story.
Meanwhile, only 56% of actively managed funds that existed 10 years ago have survived. The rest have been closed or merged. And of the original 2080 funds that survived, only one-third have retained their original investment style.
Sell-Side Fallout
Against this backdrop, computer-driven trading has doubled its share of average daily volume to 60%, up from 30% 10 years ago. In concert with this, broker commissions continue to shrink.
According to Greenwich Associates, for the 12 months through Q1 2017, total U.S. equity commissions dropped 13%. This latest drop leaves the total institutional equity wallet down 40% from its peak in 2009. This pattern is mirrored worldwide.
Source: Greenwich Associates
It’s still a large pie. But the slices are getting smaller and smaller. And more concentrated. Intense competition for ever-declining fees has led to broker consolidation.
In addition to the disappearance of household names like Bear, Stearns and Merrill Lynch during the last financial crisis, mid-tier firms like Jefferies and Oppenheimer have been absorbed into larger entities. Also of note is the consolidation among lower-tier firms. Some have merged in an attempt to gain scale, while others – some decades-old – have shut their doors.
Headcount reductions have followed lower fees in step. These include research budget allocations, as depicted in this article in the Economist.
Increased regulations since the financial crisis in 2009 have also been a factor in sell-side revenue pressure and consolidation.
And on the horizon in 2018 is MiFID II, which will force the buy-side to decouple research from trading commissions. Once fund managers have to pay for research, particularly in the face of declining AUM and fees, they are likely to reduce their sources significantly.
This will also change the sell-side corporate access function, as firms will have to explicitly price non-deal road shows, one-one-one meetings and conference admission. With concentration of companies, how many times will a buy-sider pay to have access to the same management teams? And how much will they pay to see a company new to them? Or a smaller company?
Thus, even if the Trump Administration succeeds in overturning or lessening regulatory burdens, research budgets will not reverse course. The fundamental changes impacting the client-side are permanent. This means that the trends in fees and commissions are highly unlikely to reverse sustainably.
Demographics, regulation and technology are driving a sea change on the buy-side. Business models are shifting from high-cost, low-value proprietary products to low-cost, high-quality fiduciary services. Fintech startups, some of which have been acquired by larger firms, leverage technology to appeal to younger investors with different investment goals and priorities.
To compete more effectively, traditional buy-side shops are hiring quants to try gain deeper insights into the factors that drive portfolio performance. That’s because despite an explosion in data sources – and the insatiable demand for more data – most fund complexes cannot consistently and accurately identify the input variables that drive portfolio performance.
Yet as costs for data sources and data management continue to rise, the return on that “research” continues to decline. This does not bode well for fundamental research staffs on either the buy- or sell-side. In an attempt to add greater value, sell-side firms are also investing in analytics to try to help portfolio managers identify the sources and accuracy of their data inputs. But how they should charge for this data and how much clients are willing to pay for it remain to be determined.
As a result of these factors, there are fewer analysts to cover companies. And many of those remaining have been pushed by their firms – including small shops – toward covering larger capitalization companies in the hopes of picking off a sliver of trading volume in those names.
That’s because it’s mostly these stocks that so many portfolio managers own to try to mimic index performance. So sell-siders try to provide more data points or simple hand-holding on this concentration of stocks. Is it any wonder the buy-side complains about the diminished value of sell-side research?
The days when a cadre of small firms plied their trade covering, trading in and banking micro- and small-capitalization stocks are virtually gone. There simply aren’t enough fees to cover the cost of doing business for most of them.
Why Investor Relations Must Become More Research Driven
The mission of your investor relations program should be to achieve a valuation that reflects understanding of how you will build shareholder value over time by marketing your company’s story to analysts and investors efficiently and accurately.
The “new” IR has three critical purposes beyond its traditional functions:
1. Fundamental understanding of equity markets and the investment process
2. Proactive “marketer” of the company’s story
3. Internal purveyor of market intelligence to senior management and board on sentiment and valuation drivers
IR is the public face of the company to analysts and investors. In most public companies, IR is the most frequent touch point for the investment community after the CEO and CFO.
To meet the evolving needs of analysts, investors and management, IR people will need to become more research driven. They will required two-pronged market intelligence – about what’s happening in their company’s space and about what’s happening with their space in the capital markets. IR can help management navigate short-term stock price turbulence with long-term business perspective by bridging the perception and information gaps between vision, strategy, product portfolio and markets with an investment community obsessed with data points.
Better informed IR people can also help CEOs and CFOs craft and articulate the company’s story. With the growth in algorithmic trading and big data analytics in research, IR people can be more proactive in suggesting metrics that investors find most useful to incorporate into conference calls, presentations and meetings. They can also be instrumental in managing Wall Street expectations.
This does not imply that IR people must become data analysts. But they do need to expand their sources for a better understanding of the business and the movement of their stock price. And they should do this without caving in to short term pressures.
Armed with better intelligence, IR people will have to assume more of the sell-side’s role in driving interest in the company. They will have to increasingly market the story they helped create. But a story is not created once and then left alone. Messaging must be tweaked as business and market conditions change.
Proactive marketing should include aggressive outreach to existing and prospective holders. It also includes scheduling their own non-deal road shows, selectively recruiting analysts (in and outside of their “typical” coverages), and getting the company invited to conferences. IR may also consider an ongoing series of videos, perhaps featuring certain C-levels, or possibly a YouTube channel. The more informed IR is about the business, the better educated the investment community becomes about the company.
Above all else, integrity is what underpins credibility among analysts and investors. In the current environment, I estimate that two-thirds of stock price movement is attributable to macro and market internal factors. The other one-third is messaging. So many companies get this wrong, in part because they underestimate its importance. For this, I created the 7 Rules for Wall Street Messaging.
