“Among the biggest independent companies offering research are Sanford C Bernstein in the US, Redburn Partners and Arete Research in the UK, and Berenberg Bank in Germany. Typically operating with little capital, several have come under financial pressure in recent months, including Carnegie in Sweden, Renaissance Capital in Russia and SHUAA Capital in Dubai.”
—Financial Times, “Investment research fights to prove its worth” by Adrian Cox, March 19, 2009
New York – With the Global Research Settlement’s subsidy of independent research nearly at an end, do we still need the concept of “independent research”? The idea of independent research was somewhat flawed at the outset, and, five years on, it is tired and overused. It is time to move on.
Legacy of the Settlement
In the context of our current regulatory hyperactivity, the ‘Global Research Settlement’ seems almost quaint by comparison. One of its central ideas was to stimulate a market for ‘independent research’ through subsidies. This concept failed because the bulk of the subsidy went to a half dozen larger, more established firms such as S&P, Morningstar and Argus. But the concept of ‘independent research’ had power beyond the failed subsidy: the notion of research that was genuinely unbiased, with insights that other research sources could not, or would not, provide.
In fact, the Settlement’s greatest gift to research sourced outside the investment banks was not the subsidy, but the distancing of investment banking as a source of funding for research. This helped to level the playing field, although not as much as Reg FD had done three years prior.
And the other gift from the Settlement was marketing, something boutique firms are notoriously lacking. The Settlement gave free, front-page advertising to the concept of ‘independent research’, a term with ready appeal. Not surprisingly, the term was warmly embraced by hundreds of smaller research shops whether they received the subsidies or not, creating even more buzz.
The regulators created a precise definition of independent research: research that is not affiliated with investment banking. This definition has the virtue of simplicity, and it solved the specific issues that gave rise to the Settlement. But if the goal was to define unbiased, objective research, the definition has flaws. Investment banking is not the only vehicle for generating bias. Issuer-sponsored research can also create biases, as the ratings agencies have demonstrated. Having an affiliated asset manager creates the temptation to time research reports to suit your investment needs to either accumulate or dispose of securities. Bespoke research can create inequities if it is not labeled as such, particularly if it has been embargoed. Yet all these are ‘independent’ based on the regulatory definition in the Settlement.
Outside the Settlement
Meanwhile, the marketplace for research moved on–independently of the machinery of the Settlement. Institutional investors, influenced by Reg FD as well as the Settlement, began doing more primary research, relying less on traditional sources. The rise of hedge funds spawned creativity in finding new and differentiated research sources in the search for alpha. These trends have been more powerful stimulants to research than the subsidies offered by the Settlement.
Primary research tools like expert networks and channel checkers and specialized firms like forensic research have thrived outside the Settlement. Independent consulting firms like Decision Resources or iSuppli which traditionally sold into the industries they follow now find a growing demand for their expertise from institutional investors.
In search of a new vocabulary
Now it is time for the nomenclature to reflect this reality. ‘Alternative research’ is our choice, since it reflects the non-traditional elements and acknowledges the influence that hedge funds have had on its development. We use ‘alternative’ as an alternative to ‘independent’, including fundamental boutiques as well as specialists in litigation analysis. However, a case can be made for reserving the term ‘alternative’ solely for non-fundamental research. In other words, you have fundamental research, whether affiliated with investment banks or not, and then you have everything else.
There is one other dimension to the research reality that nomenclature needs to address: bundled versus unbundled research. The regulators have polite terms they use for brokerage research that is bundled into commissions, ‘proprietary’, and for unbundled research, ‘third party’. Unfortunately, proprietary connotes more value than third party, which is true from an ease-of-payment perspective, but not necessarily from a content perspective.
So we are left with a complicated Venn diagram: investment banking-affiliated research is a subset of a larger set of brokerage research, which itself overlaps slightly with unbundled research (some brokers have dabbled in menu pricing). Fundamental research largely overlaps investment banking and brokerage research but also has a material un-bundled component while non-traditional research (ie, non-fundamental) mostly overlaps unbundled research. Bespoke research overlaps every single category. Can a few simple terms describe this complicated reality? Not really.
What about unbiased research? Where does that fit on the Venn diagram? The cynic says that unbiased research is a myth–everyone has conflicts. Perhaps, but some conflicts are better managed and disclosed than others. The reality is that conflicts can exist in research that is not affiliated with investment banking. The term ‘independent’, at least as defined by the Settlement, was fundamentally flawed.
While ‘alternative’ is an improvement over ‘independent’ in that it does not necessarily connote ‘conflict-free’, it is not a more precise definition. Our use of ‘alternative’ encompasses independent, largely non-traditional, often unbundled research…but not always. Alternative research can be bundled with commissions, it can be fundamental research, and it can be biased. Such is the messy environment in which we live.