A Tale of Two Buy-Side Investors – Part 2


New York, NY – The following is the continuation of yesterday’s blog on research procurement, valuation, and sourcing informational alpha. Much of this data for this blog was gathered through 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.). The purpose of this study was to ascertain how institutional investors sourced the external investment research they used and how they valued that research.

Research Valuation Frequency

Research Directors were also asked who regularly valued their external research services, and how frequently they valued their research. Close to eight out of ten (79%) of all buy-side research directors agreed that the regularly valued their external research. Of this universe, 35% explain they review their services once per year, 18% twice per year, 26% once per quarter, 12% once per month, and 9% continuously.Close to nine out of ten (87%) non hedge funds evaluate their external research providers. Of this group, 45% evaluate their research providers once per year, 20% do so twice per year, 30% do so quarterly, and 5% evaluate their research quarterly (no one evaluated their research continuously).Only 70% of hedge funds said they evaluated their external research providers. However, on average hedge funds did so more frequently than their cousins at traditional asset management firms. 21% of hedge funds evaluate their external research annually, 14% do so twice per year, 21% do so quarterly, 21% do so monthly, and 21% do so continuously. This means that 63% of hedge funds evaluate their research at least quarterly. This compares to non-hedge funds where only 35% evaluate their research at least quarterly.

Unbundled Prices Offered

Another question we asked buy-side research directors was whether they considered if their research providers offered unbundled prices as part of their research valuation process. Close to six out of ten (58%) acknowledged that they did consider if their research providers provided their services on an unbundled basis as a part of their research valuation process. Slightly more than half (52%) of non-hedge funds felt this way compared with almost two-thirds (65%) of hedge funds.Those that considered unbundled prices gave a number of reasons for this view, including the desire to eliminate duplication of information and the overpayment created by this duplication. Some noted that they only purchased what they needed to purchase – an approach made much easier with an unbundled pricing structure.The buy-side firms that did not consider if their suppliers offered an unbundled price explained that the price of the service did not matter as much as the quality of that service. Others said that providing transparency to their clients of what they were doing was more important than moving towards unbundling. Many noted that they preferred to pay for research with client commissions, a decision that forced them to accept a bundled model.

What Peers / Competitors Paying

Close to one third (37%) of buy-side research directors acknowledged that they considered what their peers or competitors were paying for various services as a part of their research valuation process. More than four out of ten (43%) non hedge funds noted that they tried to include competitor information in their research valuation process, compared to 30% of hedge funds who did so.Those who included data on what their peers were paying for research felt this was a good way to ensure that they were not overpaying for research they received (although the value of the research was most important).However, others felt that data on what their peers or competitors were paying for research was not relevant as what mattered was what they determined the research was worth. Others presumed that the prices research providers offered buy-side clients was competitive. The greatest group of research directors who did not use competitive pricing data did so because they found this information too difficult to collect.

Good Faith Determination

Ultimately, the buy-side must make a “good faith determination” of whether the research they are receiving from a provider is worth what they are paying for it. Most directors of research concluded that two factors were a critical part of this process, 1) Qualitatively assessing the value they received based on an internal assessment in conjunction with what the provider believes they are providing them, and 2) Evaluating the cost of the research to make sure they are not overpaying the firm for this research. However, some research directors explained that they also relied on the recommendations of their peers, the past experience and track record that a vendor has had with a firm, what they cannot produce themselves.

Other Valuable Information

The final question we asked buy-side research directors was what external information would be helpful to them in establishing their “good faith determination” of the value of the research they used. While a few research directors suggested they did not really need any outside data, most agreed that a few types of information might be an extremely useful addition to their process. This includes how much their competitors are paying for research, various measures of the proprietary or value-added nature of the content provided by their suppliers, background checks on the vendors, and competitive product comparisons.

Explanations & Consequences

The two most obvious questions to ask after reviewing these results is why are hedge funds and traditional long-only asset managers so different, and why should this matter? The answer to the first question is relatively straight forward – it is all about incentives and motivations.

Hedge funds are rewarded primarily for outperforming the market (generating alpha or excess returns) whereas long only asset managers are rewarded primarily for gathering significant amounts of assets under management. This asset gathering function is impacted by the distribution relationships of the firm, the firm’s marketing organization, track record, relationships with pension consultants, the firm’s cost structure relative to assets under management, and the firm’s investment performance relative to its peers. Consequently, the increased performance that might be generated by finding unique research providers will have a more direct impact on the financial rewards received by hedge fund managers and analysts than it would on the financial rewards received by a portfolio manager or analyst at a traditional long only shop. We suspect this is the major factor behind why hedge funds are more willing to use external sources to help them find good research, why they are more paranoid about having the best research, why developing a rigorous process to value external research is so important to them, and why they value their external research more frequently.

In addition, we expect this is the primary reason why many hedge funds are willing to spend considerably more than their non-hedge fund counterparts to acquire high quality exclusive content.So why are these differences important? The answer is all about competition – particularly in these days of convergence. You see a large number of long only asset managers and mutual funds are trying to increase their share of investors’ wallets by offering alternative “hedge fund like” investment products including 120/20 and 130/30 funds. And while we think some traditional asset management firms can compete with these new hedge fund products purely based on their distribution, we suspect it will be more difficult to compete on performance – particularly if this performance can be enhanced through the sourcing of unique and innovative research from external providers. As we discussed previously, the philosophy adopted by most traditional long only asset managers to identify, procure and value external research appears rather complacent when compared to the proactive approach taken by their hedge fund brethren. We fear that this more reactive approach could have a negative impact on the investment performance of these 120/20 and 130/30 funds when compared to their hedge fund counterparts unless these “old dogs can be taught some new tricks”.


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