New York, NY – Over the past few months, Integrity Research Associates has argued that the current credit crisis, bear market in stocks, investment fund redemptions, and resultant layoffs at, or outright closing of numerous mutual funds and hedge funds will have a severe impact on the investment research industry. However, the exact nature of this impact is related to how buy-side asset managers choose to manage the plunge in equity commissions that is likely to take place. This article addresses this topic of how the buy-side might choose to right size their research expenditures.
Resourcing Your Effort
One of the first questions a buy-side firm must do once they decide they need to reduce their research spending is to determine who will be responsible for managing this process. In the past, this would not have been a difficult decision as Directors of Research, Broker Liaisons, or their teams would have been obvious choices.
However, many buy-side firms have been slashing staff in recent months – eliminating some of the very people who would be best positioned to make informed and objective decisions about how to best right size their research spending. Due to these reductions in staff, some buy-side firms have chosen to outsource the bulk of this effort to experts in the investment research industry. These trends have prompted some buy-side firms to hire Integrity Research Associates to conduct this type of analysis.
Once a decision has been made about who will manage the rationalization their research expenditures, the buy-side firm then needs to decide philosophically how they want to approach this effort. While there are many ways to implement a rationalization effort, we believe there are only two different approaches to reducing one’s research spending.
Using a Hatchet
The first approach is to rely solely on the firm’s smaller commission budget and the broker vote. This approach is similar to cutting the budget deficit by applying a flat reduction across the board – a method that was characterized as “using a hatchet” in the recent US presidential elections. And while this approach is effective in reducing research spending, we believe it does not do a good job of rewarding those firms which have truly added value and penalizing those firms which have not done a good job of differentiated their offerings.
One of the reasons for this is the fact that historically many buy-side shops rarely ever fired research providers – particularly if those providers were part of the broker vote. Consequently, some research providers remained in the pool for years, even though they are not used much by the institutional investor because the client wanted to make sure they didn’t miss out on good ideas that provider might eventually originate. And while these providers don’t get paid much, the amount these low value players are paid in aggregate could be quite meaningful for other providers who do contribute valuable research and unique ideas.
Another problem with cutting all research providers equally through the vote is some research providers are paid via subscriptions. This means that buy-side investors need to take proactive steps and decide which of these firms they can afford to get rid of, and how hard they are going to negotiate with the firms they decide to keep.
Of course, using the vote to cut all research providers equally works much better in times when commissions fall a modest amount. However, this approach is difficult to apply in times when equity commissions are likely to fall 30% to 40% as the sharp reduction in research payments could prompt some of a firm’s most valuable research providers to cut off the supply of that research to a client.
Using a Scalpel
The second approach to right sizing your research spending is to develop and implement a more analytical process to achieve this task. A few of the questions that need to be answered in developing such a process include:
1. Who is truly providing value? This is the one question that is probably easiest to answer for most buy-side firms given the “broker vote” systems used by most. These systems enable buy-side firms to measure which research providers are considered the most useful by the analysts, portfolio managers, and traders in the firm. In addition, these systems help institutional investors to identify the specific services that clients value most.
2. Are you sure you are using “Best of Breed” research in the first place? Unfortunately, most broker vote systems do not help buy-side firms determine whether they have included the best research providers in the broker vote in the first place. In fact, most institutional investors rely on the fact that the best research providers will find them. However, our experience has shown that this is rarely the case as many of the best research providers in any sector often don’t market their expertise to mutual funds and hedge funds, nor do they participate in the various expert networks used by most buy-side analysts or portfolio managers.
3. How much redundancy do you need? One clear way to slash a firm’s research costs is to eliminate redundancy. However, this means first determining which firms provide overlapping services, and then making the very hard decision of which service / services you should choose and which you should eliminate. Part of this process is deciding which users will be upset in the process as most of the research paid for by a buy-side firm has its adherents.
4. Are you overpaying for your research? Probably the most difficult question for a buy-side institution to answer is whether they are overpaying for the research they are getting, and if so, by how much. This is based on the fact that most research providers don’t have standard “list prices” and most of these providers don’t provide much transparency on what different clients are paying for their research. Of course, part of this is due to the fact that most investment research firms offer rather complex products, providing research reports, financial models, analyst access, management access, conferences, custom research, and other related services. The other difficulty with determining if you are paying too much is coming up with a standard way to compare two buy-side clients. Different clients pay different amounts, while using different quantities and types of a specific provider’s services. Even if two buy-side firms are of a similar size, it is not clear that they will consume a similar amount of a research providers services in a similar mix.
Only after a buy-side institution can address these, and other more specific questions, can they develop and implement a more targeted process to right size their research spending.
Of course some clients might choose to combine a broker vote driven process with a more analytical approach to reducing their research spending. This might include eliminating low value providers and reducing redundancy first. The remaining research firms would then be paid out of a set commission, soft dollar, and hard dollar budgets. Those who qualify for the broker vote would be paid in that manner, while those firms who are paid subscription fees would be managed according to those soft and hard dollar budgets.
As discussed above, buy-side firms need to consider a wide range of issues to determine how best to right size their research spend, from what resources they will use to undertake this project, what approach makes the most sense for their firm, what firms will they eliminate, how they choose to manage users’ disappointment that may result from this, and how they want to manage the reduced payments to research firms they choose to keep. Ultimately, these decisions need to match up the firm’s reduced commission level, with their requirement to maintain research coverage from those research providers that truly matter, and the desire to reward those research providers that add unique insight and value to their investment process.