The following is a guest post from Colin Berthoud, Co-Founder of TIM Group, formerly youDevise Ltd, which merged with First Coverage and rebranded earlier this year.
Brokers’ trade ideas have become an integral part of the investment process across a broad spectrum – from fundamental, bottom up, buy-and-hold managers to instant-trading quant funds – influencing billions of dollars in investment decisions.
The growing number of investors who have embraced electronic trade ideas, also known as alpha capture, use them differently, such as deciding which stocks to consider for further research, timing of buys and sells, allocating commissions, or managing broker lists. This increase in both the breadth and type of buy-side usage has been mirrored by a significant sell-side investment. Today, many sales people are engaged in alpha capture for at least a part of their day, and in some cases are supported by specialists, who previously might have worked in research.
Trade ideas have existed ever since the first equity sales person called a client to recommend a stock and drum up business. The electronic era began about 10 years ago when investors such as Marshall Wace began using technology to track ideas they received from their brokers. Early adopters quickly learned that they could tailor the flow of ideas to their specific needs, track contributor performance to find the best ideas, and aggregate ideas in a manner that reinforced the individual ideas.
Unlike traditional research, trade ideas are customized by equity salespeople to meet the investment style or focus of one or a small group of clients. Ideas feature a buy or a sell recommendation (no holds allowed), suggest how much should be invested, explain the rationale, and rank the author’s conviction. While traditional research focuses on a stock’s valuation based on earnings estimates 12 months out, trade ideas typically focus on whether a stock is mispriced today, based on everything known about the stock, its industry and the macro economic scenario, and how that is likely to play out, short or long term.
When sent to clients, ideas in our system are price and time stamped and linked to benchmark indices so they can be tracked on a relative basis in real time. All ideas have to be closed within client-specified timeframes. This builds a reference database of the authors’ performance. Ideas are only sent to clients who have agreed to pay for them.
Earlier this year, TABB Group estimated the size of the pool earmarked for electronic trade ideas / alpha capture at $300 million to $500 million, with projected growth “in the range of 20% to 30% in incremental revenues globally for the next several years.” Based on reports from Greenwich Associates, TABB and others, commissions allocated to “thematic investment ideas or specific stock recommendations” drive upwards of $1 billion in commissions annually, or 7% of the $13-$15 billion spent worldwide by institutional investors on sell-side research and related services.
There are three core users of trade ideas / alpha capture systems:
- Fundamental asset managers, including some of the largest global firms, want the best ideas from the most thoughtful equity sales people, specialist sales or research analysts. These managers demand strong commentary or reasoning, and have tight idea parameters in terms of a stock’s price, volume, market cap, and/or exchange. This often translates into fewer, but higher quality and longer-term ideas, though these managers are frequently interested in shorter-term ideas to help time buys or sells. Fundamental managers can assign as much as 30-50% of their broker vote to ideas, with payments allocated based on the relative contribution of each brokerage firm’s ideas.
- At the opposite end of the spectrum are big quant funds. They like to receive a large volume of generally short-term ideas that they run through their black box trading systems. Commissions are paid in cash at the end of each quarter and skewed toward brokers who outperform. The headline numbers can be large — several millions of dollars a quarter for some of the larger bracket brokers. This is why almost every major broker has developed a trade idea business.
- In between those two groups are hedge funds. They use ideas from respected contributors as a complement to the investment process or as an efficient way to find mispriced situations. These funds generally prefer shorter-term ideas, but similar to fundamental managers, they want a strong understanding of the catalyst that is going to affect the stock’s price. The amount that hedge funds invest in an idea is often dependent upon the quality of the thesis, and involves a straight commission payment.
Based on what we see, quants account for a little less than half of all the trade idea commissions, but given their interest in high volume short-term ideas, they account for the majority of the idea volume. Fundamental and hedge fund managers account for more than half of all idea commissions, but focus on a controlled flow of ideas rather than volume.
Trade ideas are used differently around the world:
- In the UK and Europe, the buy-side has traditionally invested in strong broker relationships and has accepted their ideas as a complement to internal analysis. Thus, the majority of buy-side users of electronic trade ideas / alpha capture have been fundamental managers or hedge funds.
- In the US, it has been easier to prove the value of ideas quantitatively. Consequently, early take-up has been among quant firms. However, fundamental and hedge fund use has been growing.
- In Asia, where there are fewer research analysts, the buy-side has been happy to work closely with equity sales. Initial users of electronic alpha capture have been fundamental managers or hedge funds. As high volume electronic trading spreads around the world, Asia-Pacific quants have begun trading shorter-term ideas.
Alpha capture systems are increasingly seen by compliance departments as an effective tool for monitoring the distribution and use of content. They like the fact that regulators, such as the Financial Services Authority in the UK, have written favorably about such systems as far back as 2006; and ideas are distributed simultaneously to clients that have requested them. Sell side compliance compares the auditing capabilities of alpha capture systems favorably to less structured formats like voice and messaging, while buy side compliance likes the fact that ideas are developed by regulated entities.
First used as a sales tool to drum up business, electronic trade ideas / alpha capture has evolved to become an established, technology-driven service around the world. Today, ideas are sold by institutional brokers, purchased by a broad spectrum of clients, and play a critical and varied role in the investment cycle.
Colin Berthoud is Co-Founder of TIM Group (www.timgroup.com), which offers a trade ideas service called TIM Ideas. TIM Ideas is a web accessible, broker and client neutral platform for the sell-side to develop and send ideas to clients, and for the buy-side to receive, manage and track the performance of these ideas. TIM Ideas leads the alpha capture market today with 750 brokerage firms using it to send an average of 3,500 ideas a day to their clients at 250 quant and hedge funds and institutional investment firms.