Fidelity Unbundles Research & Execution…Again


Darien, CT – Following on the heels of its revolutionary deal with Lehman Brothers a few months ago, Boston-based mutual fund giant, Fidelity Investments, has reached its second research unbundling arrangement with Deutsche Bank Securities.
According to information published by Morgan Stanley, Fidelity’s deal with Lehman Brothers would pay the bulge bracket firm 2.0 to 2.5 cents per share for trade execution.  In addition, Fidelity decided to pay $7.0 million per year for Lehman Brother’s equity research.
Many market participants initially thought the Fidelity / Lehman deal was “much ado about nothing”.  However, in the wake of the Deutsche Bank agreement, some analysts have become a little more nervous about Fidelity’s maneuverings.  This is particularly true as rumors have been swirling about that other large asset managers are also considering similar arrangements.
Fidelity’s deals with Lehman and now Deutsche Bank have cast a sharp light on the use of “soft dollars” to pay for research.  Traditionally, money managers have paid for sell-side and third-party research using customer commissions, rather than paying for this research with their own money.
Now some large money managers are looking to unbundle their research and execution costs specifically because they want to be able to compete with Fidelity for large pension fund and plan sponsor mandates.  These firms want to be able to tell influential pension consultants that they are spending their own money on sell-side and independent research, rather than using clients assets for this purpose.
However, not all money manager’s will be able to afford to pay for research in “hard dollars”.  In fact, Morgan Stanley estimates that an industry-wide move to hard dollar purchases of research would knock off three percentage points from the average profit margin of firms in the asset management business.  The smaller managers would pay an even greater penalty.
Some argue that the cost to the industry would be more than offset by the benefit to the investor as trading commissions would fall and management costs would become more transparent.
As we discussed a few weeks ago, these developments might not benefit all investors.  In fact, we suspect some independent research and sell-side firms might choose to stop producing research altogether.  In other cases, firms will eliminate valuable types of research that cannot easily pay for itself like small cap research, technical analysis, investment strategy work, etc.
Investors that have a need for external research (particularly small and mid sized asset managers who cannot afford to set up their own research teams) may find that the actual cost of the research they require might actually go up in an unbundled world.
Below we have included the complete article written by MarketWatch revealing Fidelity’s latest move to unbundle research.
Fidelity unbundles trading costs with second broker
By John Spence
Last Updated: 12/20/2005 3:50:46 PM

BOSTON (MarketWatch) — Fidelity Investments, the largest U.S. mutual-fund company, said Tuesday it has reached an agreement with Deutsche Bank Securities to unbundle trading commissions and pay for stock research out of the fund firm’s own revenue.
The arrangement comes after the Boston-based asset manager in October said it reached a similar deal with Lehman Brothers Holdings Inc. (LEH). See previous story.
Fidelity’s moves to separate research and trading costs could have wide-ranging consequences for money managers and the brokers who handle their trades, while lowering costs for fund shareholders.
“We’re trying to move toward the funds paying commissions for trades only,” said Fidelity spokesman John Brockelman in an interview Tuesday, noting that Lehman and Deutsche are two of the company’s larger trading partners traditionally.
Fidelity is taking a strong stand on the use of controversial “soft dollars,” a common practice in the $8.5 trillion mutual-fund industry.
Soft dollars have come under increasing fire in recent years by critics who say they hide true investment costs from shareholders. Rather than paying directly for Wall Street research and other services, some fund companies intentionally overpay on commissions in exchange for research, for example. These costs come directly out of shareholders’ returns.
In October, the SEC proposed a new rule which essentially would allow the continuation of soft dollars, but would restrict how they may be used. Read earlier FundWatch.
Yet some fund companies such as MFS Investment Management, Janus Capital Group Inc. (JNS) and now Fidelity have voluntarily decided to separate research costs from trading commissions.
A high-profile fund shop such as Fidelity deciding to pay for research out of its own pocket may put pressure on competitors to follow suit if Fidelity is able to pass on significant savings to shareholders, analysts say.
The move could also squeeze profits for brokers and put heat on regulators to take a tougher stance on soft dollars.
“We are continuing to engage other brokers in discussions in an effort to reach comparable arrangements,” Fidelity said Tuesday in a statement.
The privately held firm called the deal with Deutsche (DB) “great news for our equity fund shareholders because it will result in lower commission costs on trades.”
After Fidelity’s initial program with Lehman, analysts saw possible consolidation for the brokerage industry, as well as for fund shops not as well-positioned as Fidelity and other big firms to pay for research out of pocket. Some smaller asset managers are already feeling the financial burdens of complying with new regulations, promulgated after the fund-trading scandals, which require increased oversight and administration.
Analysts at CIBC World Markets estimated asset managers typically pay between 3% and 5% of revenue to cover research costs, but the percentage is much greater at the smaller, boutique firms.
On the brokerage side, CIBC sees firms that focus more on low-cost trades and less on research as being the prime beneficiaries from any large-scale shift in soft dollars.


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