Bull Bear Report Mar 26 2010

The Waning of Analysts, Active Managers -- A New Market Risk?

By kyle stock

Layoffs in finance can signal trouble for the economy, but are they a threat to free markets and capitalism?

Yes, at least as far as analysts and active portfolio managers are concerned, according to John DeTore, an adjunct professor at MIT's Sloan School of Management and quantitative research director for GRT Capital, an active equity management firm based in Boston.

Specifically, DeTore argues that widespread shrinking of fundamental research on Wall Street has led to inaccurate share prices and an inefficient flow of capital.

In DeTore's view, analysts and active fund managers -- the people interviewing executives, poring over Securities and Exchange Commission filings and visiting production facilities -- are the grease in the gears of capitalism. Their work and recommendations help ensure that money flows to the strongest pistons -- the best business ideas, according to his argument. When there is less lubrication in the system, the engine coughs and sputters. Ailing companies don't look as bad as they should, and healthier companies don't look as good.

The volume of active investment research is hard to quantify. Data from government sources and finance groups generally don't discern between active and passive investment professionals when tallying workforce figures.

If the mutual-fund industry can be viewed as a proxy for how portfolio managers in general are faring, it would seem that active managers, though still dominant, may be losing sway.

The number of passive funds (index mutual funds and exchange-traded funds) tripled from the end of 2004 to the end of 2009, from 389 to 1,186, according to Strategic Insight. At the same time, the number of actively managed mutual funds and ETFs also burgeoned, but not as dramatically as passive funds, growing by 1.4% during the same period, from 7,961 to 8,073.

What's more, 20% of actively managed U.S. mutual funds doing business at the start of 2007 were belly-up by the end of 2009, according to Standard & Poor's Financial Services LLC.

DeTore's research is mostly anecdotal, borne of talks with large-company finance chiefs.

"Fifteen years ago, these people were interfacing with senior Wall Street analysts that had a lot of experience, knew the industry well and were writing 30- to 50-page reports on their companies," he said. "Now, what they get is someone who is really just interested in whether they are going to meet the quarter or not and maybe writing a blog on the side. … They have no prayer of someone taking the long-term view."

The ranks of analysts began thinning with the introduction of Regulation Fair Disclosure in 2000, when the SEC required public companies to disseminate investment information to all investors at the same time. Research became even less profitable, though arguably more ethical, in the early 2000s when banks were required to buttress the "Chinese walls" between the buy and sell sides of their business.

DeTore dismisses the suggestion that much of the Street's research may have been of questionable value, in light of potential conflicts of interest prior to RegFD. "There was more good fundamental research, and therefore prices as a rule better reflected future fundamentals," he said.

When the subprime crisis hit, another wave of analysts were handed walking papers or were replaced by less-experienced and lower-paid employees. Meantime, active management took a hit when investors went scurrying for cash, Treasury bills and passive Index funds.

"We just keep peeling the onion," DeTore said, referring to the dwindling research ranks. "[Equity research] has gone from Ph.D. to elementary school."

In recent years, DeTore said share prices have often diverged sharply from the underlying value of the companies, sometimes swinging like a pendulum between extremes, as investors traded on market cap and mood, rather than analyses of cash flows, growth potential and underlying assets.

But the career outlook for analysts and active managers isn't all gloom and doom, according to DeTore. When investors pour their money into cash or index funds, hustling up information typically becomes more profitable.

"We're now at the point where fundamental research is ripe," DeTore said. "The surge [in demand and profitability] that we could have over the next five or 10 years is huge."

Some investors and investment advisers seem to be buying in. Wealthy families are increasingly recruiting active managers from hedge funds, according to a recent Reuters report. And New York-based broker-dealer BTIG LLC recently started a research group, stocking up on talent from the former ranks of Bear Stearns, Lehman Brothers and Pali Capital.

Meanwhile, some of Wall Street's most seasoned analysts are still in demand. Deutsche Bank Securities Inc., for example, just swiped veteran analysts Michael Linenberg, who covers airlines, and Jonathan Arnold, who covers utilities, from Bank of America Merrill Lynch.

Whether the investment dollars will follow remains to be seen.

"We know that there are huge piles of money on the sideline," DeTore said, referring to investments sitting in cash and passively-managed funds. "The problem is, everyone is kind of looking at each other and saying: 'You go first.'"

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