Selective Disclosure: Are Trade Ideas Research?

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New York, NY – In the past few weeks, both The Wall Street Journal and New York Times have published articles discussing various instances where Wall Street stock research may have been provided to large institutional investors, without being provided to retail investors.  However, the journalists in both stories have gotten it wrong – at least in the case of providing “trading ideas” to mutual funds and hedge funds.

Stock Research, For a Select Few

Last week, the WSJ reported on the growth of a “shadow stock-research business which caters to big fast-money traders but isn’t available to retail investors.”  This is the provision of “trading ideas” by desk analysts and institutional sales people to institutional investors.

What the WSJ article neglected to mention was that this practice has been going on for decades and not just the past few years.  The most successful institutional equity salespeople have always provided their clients with “market color”, insight, and investment ideas based on their own analysis and thinking.

In fact, many brokerage firms institutionalized this practice in the fixed-income markets by moving a few of their analysts to their trading desks, because they discovered they could not commercially support their published fixed-income research departments.

In the wake of the Global Research Analyst Settlement, a number of Wall Street investment banks like Lehman Brothers, started implementing “desk analysts” or specialists on their equities trading desks to better serve their active institutional customers like hedge funds.  These former publishing analysts were hired specifically to collect information, develop short-term trading strategies, and share this information on the phone with a limited number of institutional clients.

Alpha Capture Systems Take Over

In 2001 UK based hedge fund, Marshall Wace, standardized this process by creating a computer system to collect and track the profitability of their brokerage firm’s ideas called the Trade Optimized Portfolio System (TOPS).

The firm felt that forcing its brokers to input their ideas into their TOPS system rather than using the traditional method of receiving these trade ideas via the telephone was both more efficient, and would enable the firm to directly reward the brokerage firms based on the profitability of these ideas, rather than for other less measurable factors.  Marshall Wace currently has 3,000 brokerage firm sales representatives participating in its TOPS system.

These systems have since been given the name “alpha capture” systems, and a number of firms have developed and rolled out these types of platforms, including hedge fund Two Sigma, and third-party providers FactSet and the TIM Group.

Alpha capture systems have become increasingly popular in the past few years.  Colin Berthoud, the founder of TIM Group (after the merger of YouDevise and First Coverage) explains that the number of desk analysts has more than doubled to 425, while the number of traditional research analysts has fallen by roughly 30% since 2008.  Mr. Berthoud explains, “As the research analysts have become more restricted, specialists have begun to provide information to fill the gap.”

In 2011, 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.

It’s important to note that regulators have been following the development of alpha capture systems for quite some time.  In 2006, the UK’s FSA conducted a study and published a short report on their study http://www.fsa.gov.uk/pubs/newsletters/mw_newsletter17.pdf.  In general, the FSA found the use of alpha capture systems to be quite positive from a compliance perspective due to clear audit trails, and the ease of implementing risk monitoring with these systems.

In 2011, the SEC purportedly performed a series of sweeps of alpha capture systems in the US after the Goldman Sachs ‘trading huddle’ scandal to see if unpublished research opinions or trading ideas were being disclosed to non-research employees or clients http://www.integrity-research.com/cms/2011/04/19/sec-sweeps-alpha-capture-platforms/.  It is unclear what, if anything, the SEC discovered as a result of its series of sweeps.


Are Trading Ideas Research?

The biggest mistake made by the WSJ and New York Times articles, however, is the authors have made the false assumption that the “trading ideas” provided by institutional salespeople or desk analysts which are then collected by “alpha capture” systems are considered to be research by the various regulators.

Clearly, regulators have never felt that it was necessary (or even possible) to make sure that all investors – including retail and institutional clients – receive the same information or advice from their salespeople.  But at the heart of it, “trading ideas” from desk analysts or institutional salespeople are a more formalized way of providing this type of information or advice to buy-side clients.  Instead, the regulators have always focused on making sure there was no selective disclosure of a broker-dealer’s published research reports and the associated BUY / SELL / HOLD recommendations provided by their analysts.

Unfortunately, the authors of the Wall Street Journal and New York Times articles seem to believe that broker-dealers should not be allowed to provide ANY information and advice to one set of clients (hedge funds and mutual funds) which it doesn’t equally provide to retail customers, regardless of whether the buy-side clients pay significantly more for this information than retail investors do.  I suppose this reflects the underlying view that the research, information, and advice that brokerage firms provide their clients should be a “public good” rather than a commercial endeavor which they should be allowed to generate a profit from.

 

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