Question

1. Explain the ethical problems related to the conflict of interest involving the sell-side, buy-side, and independent research firms. Do you think that MW reports can be fully trusted and used for investment decisions?
2. Relating to question 1 above, identify the parties involved in the investment process and describe their roles.
3. Are there any alternatives or any potential solutions that investors can use to alleviate the problems of analysts’ conflict of interest when they make their investment decisions? Please report as many alternatives as possible.
4. What are, according to you, the best investment approach that you would recommend when investing in the stock market to mitigate the problems of conflicts of interest? Explain your choice and enumerate the steps to follow for a successful investment strategy.

Answer 1

Ethical problems arise when there is a conflict of interest. Typically, there are three parties involved in an investment process, there are sell-side analysts, buy-side analysts, and independent analysts.

Sell-side analyst

A sell-side analyst provides the client with investment analysis and recommendations, through the research reports that his firm publishes over time. In these research reports, often the analyst gives a specific recommendation like sell, buy or hold a rating on a stock. In many cases, they give a target price for the stock based on their analysis, which might higher or lower than the current stock price.

Buy-side analyst

A buy-side analyst typically works in mutual funds, investment advisory firm or hedge funds, who manages money and hence purchase and sell securities on the behalf of the investors as well as for the firm. A successful buy-side analyst is the one who generates higher returns on his investments.

Independent analysts

These are typically boutique research firms, which are entirely dedicated to providing research inputs to their client which include investment firms as well as they sell their research reports to anyone who subscribes them. Such analysts or firms, since being dedicated fully to selling research reports, are usually expected to maintain higher objectivity than firms whose income from research advisory is minuscule.

Conflict of interests

• Most of the sell-side analysts work in the firms, which have numerous other offerings like corporate investment or High net worth investment solutions. Major revenue for most of the firm comes from serving various commercial client
• In this situation, an analyst may be under pressure to publish favorable reports which would benefit the institutional clients of the firm. For eg., a sell-side analyst might want to initiate a negative coverage on one of its institutional clients but is in conflict as this could negatively impact the firm's client relationships
• Initiating coverage on a company or industry, in which the firm's investments are present. For eg., if a firm holds corporate bonds of a renowned company on behalf of its clients or the proprietary trading unit of the same firm has invested in these bonds, a sell-side analyst may be in conflict of interest since any negative analysis would impact the firm overall.
• If the analyst's compensation is linked to the overall profitability of the firm, then a conflict of interest arises whether he/she should worry about the impact of research results on the firm's profitability and relationships or should he be unbiased in his reports
• Similar to the above situations, even for independent analysts, a conflict of interest may arise in the case, they initiate coverage on companies who have are their research report and advisory clients.

Can reports be fully trusted for investment decisions - This depends on many factors depending on the firm of whose reports are considered, the investment intellect of the investor as well as the intellect level and past history of the analysts. If the firm has a history of publishing unbiased reports, which have consistently proven correct as well as how independent the research reports are should be examined. An intelligent investor would never blindly trust research reports and would have his/her own analysis. Even if not, alternate reports on the same securities should be examined to find if any extremely different view is provided on the same security by other firms.

There are many potential solutions to alleviate the conflict of interest problem. An investor should identify firms with the following regulations and only then should consider advice from the analyst in these firms. Research analyst compensation should be strictly linked to the subscription bases of the reports and not to the overall firm

• Firms should be identified which have an equal and separate hierarchy between sell-side and buy-side analysts and are independent. Whether there are Internal protocols and strict set of coded rules and penalties in case of breach of any protocol to maintain the independence of the analysts
• Whether the self-regulatory organizations are overseeing the analyst's activities. Also, if there are any government regulations on eligibility and approval procedure of becoming an analyst. This will make sure that the only analyst who has integrity and works unbiasedly is authorized.to advise clients.

The best investment approach of investing in the stock market is doing self-analysis and subscribing to the research reports only for reference purposes. Advises by the analysts should be taken with a pinch of salt and efforts must be taken to compare if other analysts or reports project a very different view on the stock or not. Investment also depends on the risk-return profile of the investor and hence any suggestion should be considered carefully like a piece of good investment advice for a person may not be as good for another person. Also, it is important to analyze how the past recommendations of the advisors have worked out and whether there is any potential bias in the advice.