Introducing Undue “Research Risk” into Your Investment Process

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New York, – It is clear that an important issue for institutional investors is to create a rigorous and repeatable investment process that consistently generates excess returns for customers.  However, an equally important issue is to manage the risk associated with any specific investment strategy.

One extremely surprising discovery we have made in speaking with buy-side research directors, portfolio managers, and analysts is that, in many instances, asset managers are unwittingly introducing a significant amount of “Research Risk” into their investment process through their use of proprietary and independent third-party research.

This “Research Risk” is related specifically to the reliability, credibility, and objectivity of the external research they use, as well as the ongoing operational risk imbedded in these research businesses.  Some of the factors we look at when trying to assess the “research risk” of a research provider, include:

u      Financial Stability

u      Overall Firm Business Model

u      Money Management Affiliations

u      Analyst Compensation

u      Ownership Structure

u      Management Backgrounds

u      Research Best Practices

u      Compliance Policies & Procedures

u      Research Disclosures

u      Litigation History

Historically, buy-side money managers relied heavily (if not solely) on insights, ideas and recommendations provided by sell-side investment banks and broker-dealers.  Independent providers comprised a minute part of their research spend.

In recent years, a large number of buy-side firms have been relying more on internal research, rounding out their requirement with sell-side research, as well as ideas and insight generated by innovative boutique research providers.

Unfortunately, the buy-side has assumed that all research — including sell-side and independent — is “created equal”.  Consequently, asset managers have erroneously accepted the view that hiring third-party research providers introduces little to no risk into their investment process.  This could be due, in some part, to the misunderstanding that most independent research providers are not regulated entities as they are legally seen as “publishers” rather than broker-dealers or investment advisors.

The error of this thinking has been made clear in a number of instances in recent years where firms have discovered that the “Research Risk” of certain research providers has been unexpectedly high.  Some of these scandals include the Global Research Analyst Settlement, the Overstock and Biovail lawsuit against Gradient Analytics, and the Seattle Times article suggesting that hedge funds are using expert networks to obtain insider information on clinical drug trials.

Surprisingly, many buy-side firms have yet to wake up to the potential legal,  fiduciary, public relations, and real investment losses that could result from hiring third-party research firms without conducting detailed due diligence about their research providers management expertise, analyst backgrounds, research processes, operations, and policies and procedures to mitigate conflicts of interest.

As we have written in the past, the mere fact that buy-side firms do more due diligence on internal analysts they hire than they conduct on external research providers (from both investment bank and independent providers) is clear evidence that investors assume that these sources of insight, analysis, and ideas won’t introduce undue risk into their investment process.

Unfortunately, this view is an extremely flawed and potentially dangerous one for the industry.

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