New York, NY – The following article has been submitted by William Russell Smith, Managing Director of AQ Research, a UK-based consultancy that analyses sell-side research data from over 200 investment banks, brokers and independent research houses operating in 50 markets worldwide.
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For those readers who have attended the AQ Research conferences over the past couple of years, you will know the vigorous debates that have taken place regarding the various ways the buy-side might reward investment research in the future.
The professionals at AQ Research have been contributing to the debate by conducting surveys and the project that the firm commissioned from the London Business School in the first part of 2005. In this project, AQ Research looked at various pricing and payment mechanisms that exist in other intellectual property markets and tested their suitability for investment research by talking to people on both the buy-side and sell-side.
During 2006, AQ Research appointed Albert Alonzo as the firm’s Research Director. Mr. Alonzo worked together with Mr. Russell Smith and the team at AQ Research to develop products that would help the industry price investment research. Albert might be familiar to some of you in his previous roles on the buys-side (at F&C where he was working in the area of research assessment until February) and the sell-side (starting at BZW and most recently at Metzler).
Albert Alonzo also spoke at AQ Research’s April 2006 conference on the provoking topic of research procurement. “Typically research is one of the most significant costs that fund managers face, after staffing costs. Yet with the payment mechanism of commissions, control of this cost has been variable across the fund management industry,” Alonzo says. The big operational risk for fund managers is that this cost becomes “hard” in the future (i. e. paid out of the fund manager’s P&L). In this case, fund management groups would be faced with the prospect of either raising management fees in a competitive market or seeing their own margins evaporate.
AQ Research has invested a lot of time over the past nine months meeting with fund managers to understand what they want and their thinking on this subject. “Fund managers seem to be polarized into two camps — those that are engaged with unbundling and those that are treating it more as an issue for compliance” says Russell-Smith, having notched up over 20 meetings with a broad range of fund managers in the UK.
WHAT THE BUY-SIDE WANTS
Some themes have emerged regarding the buy-sides needs:
* A continuing dependence on the sell-side to provide investment research, and a preparedness to pay for it,
* Avoiding “hard” research payments if possible,
* High quality research (unsurprisingly!) from a diverse range of inputs (particularly valued by hedge funds)
* The desire to maintain existing and increasingly strategic partnerships with some brokers,
* More transparency in the pricing of the research service, but unsure how this might be achieved given the reluctance of brokers to enter bilateral pricing discussions.
Broadly, the process for deciding on research payments is as follows: the fund manager decides on a sum to be allocated in total commissions — a sum that seems largely grounded on historic payments that have been made. The split between research and execution is made by comparing bundled rates (in bp) offered by brokers with execution only rates, to give a percentage split, that is then applied to the total. The research commission is then divided up between the investment teams according to the mandates held, with each team head further allocating it between the individual investment managers, who then vote on the brokers. The series of allocations is calculated to give brokers their research commission, with (in certain cases) feedback on their past performance.
There is an acceptance that as unbundling unfolds, this more or less traditional business model of research will not hold. At the moment brokers remain reluctant to cut fund managers out of a research distribution, and large fund managers are confident that they can get what research they want by calling brokers. CSAs are now being widely implemented, and are used to reward brokers in the “long tail” who must be seeing execution payments disappear.
WHAT THE SELL-SIDE WANTS
AQ Research has also maintained their regular series of meetings with brokers and pricing has been naturally a topic. In these meetings a number of consistent themes have also emerged:
* Budgeting for research when payments are essentially transaction driven
* How to know what parts of the service are truly valued by fund managers
* Answers about what to do with marginal research
* How to maintain research in out of favor sectors
The survey of sell-side firms conducted earlier this year showed that brokers were proposing to establish unbundled research costs through negotiations with fund managers. As can be seen from the reality of the processes within fund management groups, this seems to have evolved as a one way process: the fund manager tells the broker what payments will be made, the broker complains that this is not enough (generally without success) and then might adjust the position of the fund manager on the call list, if CRM systems allow this.
FROM EVALUATION TO VALUATION
It is clear that there is a gap between the brokers and the fund managers, with neither of them prepared to show the first hand. But interestingly, there are also some common needs e.g. greater clarity of costs/revenues, eliminating what’s not valued, maintaining diversity of inputs.
What AQ Research proposes is to develop a marketplace for research – AQREX (standing for the AQ Research EXchange). This fits between the research providers (e. g. brokers) and the research consumers (e. g. fund managers), as shown in the figure below.
The key principles are:
* Based on buy-side ex-ante procurement process, not ex-post evaluation, ranking, & allocation,
* Enabling research providers to give a range of prices for each type of research, and for fund managers place purchase orders in this range according to their relative negotiating position.
* At the research consumer, purchases are consolidated at a research procurement “hub” for internal and external negotiation
NAVIGATING THE RESEARCH MARKETPLACE
The team at AQ Research expects to expand on this discussion, as well explore a number of related themes in greater detail at their forthcoming conference, “Navigating the Research Marketplace” that will be taking place in London on March 14-15 2006. For more details about this upcoming conference, please see their website www.aqresearch.com