'Expert Networks' Are Back, Thanks to MiFID II
This post originally appeared in Money Stuff.
Here is a story about the return of "expert networks" -- companies that connect investors with subject-matter experts for background conversations, for a large fee -- that is fascinating on all sorts of levels. For one thing, it is a story of unbundling: The article frames the renewed interest in expert networks (which became less popular after they were involved in a string of insider-trading cases) as a response to new European MiFID II rules that require investment firms to pay for research directly rather than receiving it for "free" from banks and compensating the banks with trading commissions:
Now that banks have stopped giving equity research for free under a new European Union law, some money managers are opting instead to spend their cash speaking with experts in fields as trendy as artificial intelligence or as niche as sausage packaging.
If your research and trading are bundled together, your standards for research are lower. If you have to pick a bank to help you buy shares of a sausage company, and if one bank sends you a nice five-page background report on that sausage company complete with a financial model, you will no doubt feel warm feelings toward that bank and be inclined to use it (and pay it a commission) to buy the shares. On the other hand if the bank asks you for thousands of dollars for that background report you might decide to comparison-shop. Maybe there is someone out there who knows more about sausage-making than an equity analyst at a bank? Perhaps you should be giving that person your money?
Obviously you will still use some bank to execute your trades -- the sausage savant can't help with that -- but you will pay it less. You would expect this to be more efficient -- you can pick the best and most cost-effective sausage expert, and the best and most cost-effective execution trader -- unless there are any economies that come from combining sausage expertise and execution trading in a single firm. You can see why European regulators might think there wouldn't be.
Also striking are statements like this:
Hermes Investment Management, which allocates almost 33 billion pounds ($46 billion) of client money, started using expert networks a couple of years ago for niche perspectives on areas like geopolitical risk, urbanization and automation. But “it would be dangerous and probably somewhat foolish to rely on them solely without additional work yourself,” investment chief Eoin Murray cautioned.
“I can provide some of the financial institutions information in five minutes that takes them weeks and months to acquire through their due diligence and data analysis,” said Plank.
These statements sound pretty straightforward and normal, but what is strange about them is the distinction they draw between talking to an expert, on the one hand, and "work" or "due diligence" or "analysis," on the other. You see this sort of thing a lot in discussions of insider trading, particularly when prosecutors are doing the discussing. The idea is that there is some sort of quiet virtuous manual labor -- digging holes and filling them up again, or reading and highlighting 10-Ks -- that securities analysts are supposed to perform, and that makes markets more efficient, but that those analysts are somehow cheating and shortcutting the process when they just call someone up and ask him to tell them the answer.
This, it seems to me, is mostly the wrong way to think about securities analysis. You can never add information to the market just by reading 10-Ks; the information is already in the 10-K. The way to add information is to find things out that someone knows -- perhaps an insider, or perhaps just a guy who knows a lot about sausages -- but that no investors know yet. The work, the due diligence, the analysis, regularly consists of calling people up and talking to them. If you assume that those phone calls are cheating then you will have a distorted view of how markets work.
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