Credibility Outshines Unique Insights

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New York, NY – Recently, the team at Integrity Research Associates conducted a survey of buy-side analysts to determine what factors were the most important drivers in the selection of external research providers (produced by sell-side and alternative research firms).  Based on this survey, the buy-side explained that the credibility of the research provider is the most important factor in selecting external research providers – even more important than unique industry or company insights.

Survey Results

The survey of 50 hedge funds and mutual funds conducted in the late spring and early summer of 2007 revealed that buy-side analysts ranked the “Credibility of the Research Provider” as the most important out of eight factors in selecting external research, generating an average rank of 4.56 out of 5.  Analysts at both Hedge Funds and Mutual Funds agreed that firm credibility was the most important selection criteria in choosing sell-side or alternative research.

Factors in Choosing External Research Providers

TOTAL

HEDGE FUND

MUTUAL FUND

Credibility of research provider

4.56

4.67

4.50

Unique company insights

3.92

4.10

3.90

Depth of research

3.90

4.10

3.75

Unique industry insights

3.86

4.10

3.75

Credibility of analyst

3.86

3.62

4.20

Transparency of research

3.78

3.90

3.75

Access to analysts

3.26

2.95

3.45

Performance of recommendations

2.96

2.76

3.25

On an overall basis, “Unique Company Insights” ranked second in this survey out of eight factors, posting an average score of 3.92 out of 5.  Analysts at Hedge Funds felt that “Unique Company Insights“, “Unique Industry Insights“, and “Depth of Research” were deemed to be equally important in the external research selection process.  Mutual fund analysts, on the other hand, felt that “Credibility of the Analyst” was slightly more important than company insights.
In total, the buy-side analysts we surveyed felt that the third most important factor in selecting external research was the “Depth of the Research“, posting an average ranking of 3.90 out of 5.  However, hedge funds ranked “Transparency of Research” next, whereas mutual fund analysts thought “Unique Company Insights” ranked third.
While these factors were seen as the most important in selecting external research, it was not surprising that the quantitative performance of a firm’s research calls was relatively unimportant in the selection process of an external research provider.  In fact, in our survey of buy-side analysts, “Performance of Recommendations” ranked last, with a score of 2.96 out of 5.

Some Surprises in these Results

On the one hand, it is easy to understand how brand name and reputation are extremely important to buy-side analysts when selecting external research sources.  However, it seems a little strange that analysts are more influenced by firm credibility than by other factors that represent the quality of research like company / industry insight, or the depth and comprehensiveness of the research.
In fact, this trend was even more pronounced when evaluating the results of mutual fund analysts who ranked firm and analyst credibility as their top two factors in selecting external research.  As a result, we suspect that well-known and respected research providers will be at the top of most analysts lists when they choose sell-side or alternative research, whereas small, lesser known boutiques will find it more difficult to gain mind share with many of these analysts.

One unexpected factor that was highly rated in our recent survey was the importance of “research depth”.  The explosion of sell-side and alternative research providers in recent years has led, in many instances, to a cry for brevity and concise research from many clients who have become so inundated with research that they cannot keep up.  However, it is understandable why full-time analysts might judge a research firm’s value by the depth and comprehensive nature of the research they produce.
In countless surveys in recent years, the buy-side has rated access to analysts as one of the most valuable parts of external research.  Consequently, it was somewhat surprising that buy-side analysts ranked “Access to Analysts” seventh out of eight, with a score of 3.26 out of 5.  Perhaps this is because buy-side analysts expect this from their suppliers, and therefore it is not a real differentiator when selecting third-party research providers.

It is important to note that many alternative research providers do not aggressively market analyst access.  This is due to two factors.  First, many of these firms generally perceive that the primary value of their offering is their research reports.  In addition, many of these firms do not have sufficient analytical resources to be able to spend significant amounts of time interacting directly with clients.
However, various studies have shown that the value of sell-side or independent research firms’ research reports has become less important to most buy-side clients than access to company management, or access to the analysts themselves.  In fact, numerous industry executives are starting to agree that traditionally company research reports are merely “advertising” for the company knowledge and industry expertise of the research analyst.

Comment by Scott Drysdale:
Research credibility always stems from efficacy. What is an insight if it’s unrelated to how the stock does? How does an analyst or a PM use anything if not to pick stocks? Does an analyst gain credibility by not accurately calling stocks?

Part of the fun with surveys is that they never ask these questions. Isn’t it interesting that in the II polls, the commentary about the winners, et al always centers on recommendation efficacy?

With respect to sell side versus buy side performance, a host of factors come into play. PMs have no Holds, even those who think they do. A stock held in portfolio is always bought. Therefore, a PM lives with performance that is time weighted whereas all of the sell side analyst ratings that I’ve seen are not.

Similarly, a PM has a portfolio-weighted position that is impossible to replicate on the sell side. That doesn’t mean it’s impossible to measure sell side analytical performance. But, it makes comparability of returns with a PM impossible. It’s the difference between how many touchdowns one scores in practice versus those produced on game day.

In a nutshell, what we know is that despite the surveys, the buy side clearly isn’t paying for what they have been getting from the sell side. PMs continue to struggle to beat passive indices. At the end of the afternoon, sell side analysts either help pick stocks or they’re, what?

We at SMH Capital are developing a proprietary research product that is built around efficacy. We know of no better way to build credibility — and earn the buy side’s business.

Scott J. Drysdale
Director of Institutional Research Marketing/Equity Sales
SMH Capital
600 Travis St, Ste 3100
Houston, TX
713.250.4240

Comment by Bill George:
Over the last few days the Integrity Research Associates’ ResearchWatch web log has been discussing the performance of several research providers based on the performance of these research providers investment recommendations as tracked by InveStars.(1)

After looking at the performance of these “research providers” one might be tempted to fire one’s asset manager(s) or switch mutual funds.

To be fair to buy-side asset managers I believe it’s important to note some performance advantages that investment “recommenders” have, that buy-side asset managers typically don’t have:

(1)Sell-side recommendations may produce excess returns because of the demand the recommendation can create for the recommended security. This is particularly true when the firm recommending the security has significant distribution resources and mounts a strong marketing and sales campaign around the recommendation. This effect is usually most evident when the recommender’s firm has a vested interest in the performance of the recommendation by virtue of conflicts of interest created by: investment banking arrangements, internal asset management interests (including principal trading), or front-running schemes with favored clients (I call this the Grubman-Blodgett affect).

(2)Buy-side asset managers are at a performance disadvantage to sell-side recommenders because buy-side managers must actually implement recommendations. Such implementation will generally have market impact which will move the security pricing in the direction of the new “target value”. Market impact and security valuation change ‘at the margin’* and are highly dependent on the liquidity of the security issue and supply and demand for that issue of the security at any point in time.
(3)Buy-side asset managers are also at a performance disadvantage to sell-side recommenders because the implementation, management, and the holding of securities positions forces buy side-managers to pay commissions, custodial fees and other overhead costs. Recommenders do not generally have to “net” their performance against any fees for acquisition, management, or maintenance of the securities they recommend.(2)

* To conceptualize the re-pricing ‘at the margin’ it’s helpful to think of the way home appraisals are done using “comps”. Appraisers of home values generally look for comparable, or near comparable, homes in the same area as the home being appraised, and then they assign value based on the degree of comparability of the most similar homes. All securities in the same issue are homogenous, so comparability is instantaneous and the re-pricing of an entire issue will respond rapidly to changes in supply and demand for the issue. They used to call it “reading the tape”.

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