Share-cropping

May 17th 2007
From The Economist print edition

Hard-hit equity traders are fighting back


IT IS not just in the debt markets that risks are being divided into their component parts. The equities business, too, is splitting the financial atom. The profitability of share-trading by large investors, which used to be at the heart of brokerage, has fallen since the collapse of the dotcom boom. The old system, in which brokers provided money managers with research as well as orders, in exchange for plump commissions, has been overtaken by electronic transactions in which shares are processed cheaply in vast shoals. Since 2003 the 20-year decline in commissions at the largest firms has been accelerating (see chart 7). Firms have weathered the storm because of a pick-up in equity underwriting, which is highly profitable. But when the cycle turns, equities trading and research will need to change. Big wallets and sharp wits will be needed to survive.

The biggest clients, such as mutual funds, did themselves a lot of damage with their lemming-like behaviour during the internet bubble, and are exposed to competition on many fronts. Hedge funds are chipping away at their business, charging high fees in exchange for the promise (often unkept) of performance above stockmarket benchmarks. Cheaper index-linked products such as exchange-traded funds have also undercut the money-management business. Mutual funds, in turn, have taken their troubles out on brokers, squeezing trading costs even lower.

As commissions have fallen, hedge funds have helped ease the pain for the brokers. They turn over share portfolios so quickly that they partially make up in increased volume what dealers lose from lower fees on each trade. Hedge funds have also developed lucrative prime-broking relationships with a trio of investment banks that moved into the business early—Morgan Stanley, Goldman Sachs and Bear Stearns—borrowing money and shares from them and often paying a lot for advice. But the profitability of the prime-brokerage business has attracted many other investment banks: Lehman Brothers, Merrill Lynch and Deutsche Bank are all energetic late entrants. Mr Hintz of Bernstein Research reckons this may have brought down prime-brokerage returns for all.

The increasingly clear divide between active investments—those that attempt to beat the market—and passive investments, which attempt to track it, is also changing the business. For example, the mutual-fund industry is becoming split between dirt-cheap algorithmic index-tracking and higher-margin products that either include hedge funds or try to emulate them.


One of the fastest-growing segments is 130/30 funds, which borrow heavily from the long/short hedge-fund model. Merrill Lynch estimates that assets under management in such funds total about $50 billion. Besides making it possible to carry long-only positions (a bet that selected stocks will rise), they also allow 30% of long stocks to be leveraged and 30% to be sold short (or borrowed and sold on the assumption that the price will go down). This type of fund requires greater stock-picking skills from a manager than a plain variety and commands much higher fees. It is also subject to the law that not everyone can beat the market all the time.

Brokers go for broke
Brokers, for their part, are also putting more of their capital into supporting their own and their clients' equity punts, ie, acting as principals rather than agents. Equity derivatives are flourishing, which means brokers are increasingly making their own leveraged bets in order to write hedging contracts for clients. Rohit D'Souza, head of global equities at Merrill Lynch, describes this as “providing capital to support our clients' ideas”—much as his fixed-income counterpart would.

On top of this, proprietary risk-taking is increasing. According to Mr Hintz, Wall Street's equity-related value at risk (VAR), which estimates the amount it could lose in a short period if markets fell sharply, has soared from about $80m in 2002 to upwards of $140m last year. Somewhat reassuringly, profits appear to be rising faster than the VAR. Clients, however, worry that their ideas could at best be copied, at worst used against them, by the proprietary-trading desks. Some of this, such as “front-running” (a broker trading on its own account before executing orders submitted earlier by the customer), is illegal, but is thought to go on all the same.

Maria Jeeves
Their excesses during the dotcom boom are coming to haunt equity traders. America's Regulation National Market System and the European Union's Markets in Financial Instruments Directive (MiFID) will require brokers to pursue the best possible deals for clients rather than automatically funnel them through their own systems. This has already produced quite a flurry of rival electronic platforms offering low prices.

Analysis of companies, too, is under pressure. In America research was split off from investment banking in 2003, with painful effects. Mr Hintz reckons research budgets on Wall Street fell by a third between 2000 and 2005. In London regulators are forcing banks to disentangle the cost of research from the cost of trading, which leaves many wondering how analysts will pay for themselves.

Who needs research?
But there is a fighting spirit in the research departments, just as there is on the trading floors. Candace Browning, head of global research at Merrill Lynch, displayed it in March with a letter to clients complaining bitterly that research was being “Napsterised” (referring to Napster, the website that pioneered free music downloads). She condemned the “never-ending litany” of statements predicting the demise of research carried out by investment banks, and vowed to deny non-clients access to such research.

In fact, investment-banking research departments do have a future. Like trading desks, they have to become more bespoke, catering to hedge funds and others who want ideas that will generate fast profits. But they will live and die by their quality, not by the big names of their employers. If their independence is compromised, as it so often has been in the past, there are plenty of up-and-coming boutiques to steal their clients from them.