A Tale of Two Buy-Side Investors – Part 1

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New York, NY – Anyone who has ever sold investment research services to the buy-side for any length of time will tell you that not all institutional investors are alike, depending on their assets under management, their investment strategies, or their business models. However, what we recently discovered is that these differences even impact how buy-side firms source and value external research. And while many might find this self evident, we suspect these differences could have significant consequences for institutional investors – particularly as convergence prompts many long only asset managers to offer alternative investment products like 130/30 or 120/20 funds.In October of 2007, the team at Integrity Research Associates conducted an informal survey of 43 Directors of Research at US based hedge funds and non-hedge fund institutional investors (long only asset managers, mutual funds, etc.). Slightly more than half of the survey respondents (53%) worked at traditional long only firms, whereas slightly less than half (47%) worked at hedge funds. The purpose of this study was to ascertain how institutional investors sourced the external investment research they used and how they valued that research. The following is a review of the findings of that survey and a discussion of the implications of these findings.

It must be noted that this survey was in no ways “statistically significant” and therefore the results can only be considered indicative readings and not quantitatively reliable.

How the Buy-Side Identifies External Research

One of the initial questions we asked the group of DOR’s was how their firms identified good external investment research. Over 9 out of 10 survey respondents (91%) indicated that their analysts and PMs were their primary vehicles to source good research. Over 8 out of 10 (84%) said that they discovered good research as a result of being contacted by the salespeople at the research firms themselves. Slightly more than one quarter (28%) explained that others at the firm helped identify good research. An identical number (28%) also noted that they relied on external sources like the commission management groups at their investment banks or brokers, independent research consultants, or other research aggregators to help them identify good research.All of the Directors of Research at Long Only Asset Managers and Mutual Funds explained that their PMs and Analysts helped them source good investment research (100%). This compares to 80% at hedge funds. Close to 9 out of 10 traditional asset managers (87%) also cited research salespeople as a major way they discovered good research, whereas 80% of hedge funds got their research leads from salespeople. Approximately one quarter (26%) of long only asset managers noted that others within the firm helped them source good research, compared to 30% of hedge fund managers. Slightly more than one out of ten (13%) of the DOR’s at non-hedge funds surveyed explained they used external sources to identify good research. However, the big surprise came from the results we gathered from hedge funds for this question, where slightly less than one half (45%) of all hedge funds claimed to use external sources to help them find good investment research.

Confidence in External Research Sources

A second question we asked of Buy-Side Directors of Research was how confident they were that they had found and included the best external research as a part of their investment process. As you might expect, a large percentage of institutional investors were highly confident they had found the best investment research, while a relatively low percentage were concerned that they might not have found the best external research. On an overall basis, 42% of all buy-side directors of research felt either extremely or very confident that they had found and included the best external research as a part of their investment process. In addition, only 24% felt Somewhat or Not Too Confident they had found the best external research.Slightly less than half (48%) of the Directors of Research at Non-Hedge Funds felt either Extremely or Very Confident they had found the best sources of external investment research. This result was more than two and a half times the percentage (18%) of Non-Hedge Fund DOR’s who felt Somewhat or Not Too Confident they had found the best external research.However, Hedge Funds revealed significantly less confidence that they had been able to identify the best external investment research as a part of their process. Slightly more than one third (35%) of those surveyed indicated they were Extremely or Very Confident they had identified and integrated the best external research as a part of their investment process. This compares to slightly less than one third (30%) who were either Somewhat or Not Too Confident they had found the best external research. Surprisingly, the percentage of hedge funds that were not confident they had found the best research was almost equal to the percentage that were confident they had found the best research.

A Process to Value External Research

Buy-Side Directors of Research generally agreed that developing a rigorous process to value external research is important to the firm, with 40% of those surveyed noting this was either Extremely or Very Important. Slightly less than one third (32%) of those surveyed felt that a rigorous research valuation process was either Somewhat or Not Too Important to their firms.Slightly more than one-third of Non-Hedge Funds (35%) felt that developing a rigorous process to value external research was Extremely or Very Important to their firms. This was identical to the percentage who felt it was Somewhat or Not Too Important.On the surface, Hedge Funds had a similar view with 45% feeling that developing a rigorous process to determine how to value external research was either Extremely or Very Important to the firm. This compared to 30% who felt it was Somewhat or Not Too Important.

One interesting difference between hedge funds and non-hedge funds was the fact that 25% percent of hedge funds felt that developing a rigorous research valuation process was Extremely Important to the firm, whereas only 13% of non-hedge funds felt the same way.When asked if they felt such a process would become more important in the coming twelve months, a large percentage of buy-side investors felt that it would for a variety of reasons. A few reasons that were cited most often for this increase in importance includes the decline in the value of Wall Street research and the increased difficulty in finding unique research that others do not have. Some also noted that commission transparency and unbundling was forcing many asset managers to have to pay more and more research out of their own pockets. Consequently, these managers want to make sure they only pay for the research that is “must have” versus paying for whatever research their PMs and analysts would like to have.Buy-Side Directors of Research were also asked to explain the primary factors they included as a part of their research valuation process. Despite the fact that most acknowledged that they used a qualitative process of gathering analyst and PM input to value their external research (broker vote system), most also disagreed over what metrics mattered most to them to determine value.

The suite of services provided were seen as extremely important, including access to management, analyst visits, conferences, written materials, trade ideas, portfolio strategy, etc. Timeliness and turnaround of research was also considered to be important. The predictive ability of the research was also seen to be critical (performance of their recommendations) to some investors. The cost, ease of use, and the uniqueness of the information provided was also considered an important part of the research valuation process. Some even noted that they compared research providers with other providers of similar services to help determine the fair value of that research.

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