Are Large Buy-Side Research Departments Justifiable?


New York, NY – In recent years, commentators, journalists, and analysts have agreed that most institutional investors don’t value sell-side research as much as they used to.  In fact, the argument goes that the buy-side’s increased hiring of analysts in recent years has been a reflection of this reduced reliance on the sell-side and an increased reliance on their internal own research capabilities.  However, as the market environment has become extremely difficult the question is, “Can the buy-side continue to justify their investment on large internal research departments — particularly when they can easily leverage the research and expertise of large numbers of sell-side and alternative research providers?”

A Significant Investment

Over the past 5 to 6 years, U.S. buy-side institutions have been investing a great deal in hiring new analysts to increase their internal research capabilities.  In fact, up through 2008, buy-side directors of research consistently reported that they planned to hire more analysts during the year.  One noteworthy example of this was Fidelity’s highly publicized investment of $100 million in 2006 to double their number of research analysts on staff to 150.

Consistent with this trend, in 2008 Greenwich Associates reported that the average U.S. buy-side institutions increased the number of equity analysts they employed from slightly less than 10 analysts in 2006 to between 11 and 12 analysts in 2007. This result reflected no change in the number of equity analysts at hedge funds, while mutual funds saw close to a 50% increase from just over 12 analysts in 2006 to slightly more than 18 analysts in 2007.

These trends are reflected in Integrity’s forecast, which reveals that U.S. buy-side institutions (mutual funds, pension funds, and hedge funds) spent approximately $6.6 billion in 2008 on their internal research capabilities.  This total includes primarily salaries, bonuses and benefits for buy-side research analysts and support staff.  However, we also included the costs of technology and software systems to support the research function; information services including market data systems and databases; and other overhead expenses in our forecast.

Do Buy-Side Analysts Measure Up?

So an obvious question that follows is whether buy-side analysts are worth the investment made by their firms, or would asset managers be better off relying on analysts from sell-side or alternative research firms.  One academic study, published in October 2008 by Professors Boris Groysberg, Paul Healy, Craig Chapman, and Devin Shanthikumar of Harvard Business School and Yang Gui of the University of North Carolina, Chapel Hill examined the performance of buy-side analysts relative to sell-side analysts to determine which type of analyst was better.

The results of their research showed that between 1997 and 2004 buy-side analysts at one large well-known investment management firm (ranked a top 10 firm by assets under management) made less optimistic stock recommendations than sell-side analysts.  However, the earnings forecasts of these buy-side analysts were more optimistic and inaccurate than those made by the sell-side analysts who were evaluated, and the returns to their buy recommendations under-performed the recommendations provided by sell-side analysts.

In an effort to assess the performance of sell-side analysts against a larger universe of buy-side analysts, the study compared sell-side analyst recommendations against the investment decisions of portfolio managers who stated they rely exclusively on buy-side research.  This study also revealed that sell-side analysts were superior to their buy-side counterparts. According to the authors of this study, these performance differences appear to be partially explained by the buy-side’s higher retention of poor-performing analysts and by differences in performance benchmarks used to evaluate buy- and sell-side analysts.

Of course, the weaknesses of this study included the fact that the authors could not get direct recommendations for a large number of buy-side analysts across a number of institutions.  Relying on the actual decisions of portfolio managers may or may not reflect the accuracy of the analysts supporting them.  In addition, this study also focused specifically on long-only asset managers.  Hedge fund analysts were specifically excluded from the study.  Nonetheless, this study does suggest that buy-side analysts might not be bringing the value add that money managers originally thought they would when they decided to expand their ranks.

Sell-Side & Alternative Economies of Scale

It is also clear that building large buy-side research departments may not be cost effective – particularly when asset managers have a large number of alternatives like sell-side and alternative research providers that have considerably more economies of scale than they do.

As we mentioned earlier, the average mutual fund had 18 research analysts, while the average hedge fund had between 11 and 12 analysts in 2007.  These research teams each serve one client – the asset manager who hired them.  However, sell-side firms and some of the larger alternative research providers have this many (or considerably more) analysts who serve dozens or even hundreds of asset management clients.  As a result, these firms often can afford to hire the best and brightest analysts as they can spread the cost of their research teams across a large number of customers.

For example, a study conducted by Professors Groysberg, Healy, Chapman, Shanthikumar and Gui, published in 2008 showed that in 2005, the average compensation for sell-side analysts was approximately $800,000.  On the other hand, we estimate that buy-side analysts in the United States earn an average of between $450,000 to $500,000.   Not only does this support the contention that sell-side firms can afford to pay more than the average buy-side firm – enabling them to hire some of the best analysts – but it also reveals the benefits associated with spreading this cost across a large number of clients.

For example, a small sell-side or alternative research firm with 10 analysts could have a research budget of $10 million.  A buy-side firm with a similar number of analysts could be spending $7 million per year on their internal research department (not including the cost of external research).  If the sell-side firm has 30 buy-side clients, the firm would need to generate just $334,000 per year to cover the cost of the research department.

Even if the firm decided to charge twice that amount to generate an acceptable profit margin (or $668,000 per client for access to their research) this would be considerably less than the $7 million required to support their own internal research department.  If the buy-side firm paid the same $668,000 for access to 10 different sell-side or alternative research firms, they would spend slightly less than they would spend to support their own internal research department, and they would have access to 100 sell-side and alternative analysts versus their own 10 analysts.

Of course, we are not suggesting that buy-side firms should eliminate their internal research departments and rely solely on sell-side or alternative research firms.  However, we are pointing out the economies of scale enjoyed by most sell-side and alternative research providers that buy-side firms could take advantage of – particularly in the difficult financial market environment that currently exists.

Changing Perspectives from Some

While not a widespread phenomenon, in the past few months we have heard of a small but growing number of buy-side firms both here in the U.S. and in Europe that have decided to radically reduce their internal research staffs and focus instead on purchasing the best research from sell-side and alternative research providers.

We suspect that, in normal times, very few buy-side firms would choose to slash their internal research departments and outsource their idea generation to the sell-side or to alternative research firms (although this is exactly what most buy-side firms did a few decades ago).  However, these are not normal times as plunging stock markets and huge redemptions are forcing most asset management firms to dramatically tighten their belts.


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