The Buy-Side: Unbundling and Internalizing Research


New York, NY – In recent weeks, the team at Integrity Research Associates has been discussing how unbundling, commission transparency, and the use of CSAs and CCAs might impact our outlook for sell-side and alternative (aka independent) research.  Of course, one missing part of this discussion has been, “How will unbundling influence the investment the buy-side makes in its internal research capabilities?”  This week we will address this issue.

A Historical Perspective

Until the beginning of this decade, most buy-side firms used their internal research groups in a very different way than they do today.  In the 1980s and 1990s, many buy-side analysts aggregated, evaluated, and developed consensus views based on the research, analysis, and recommendations generated by external analysts, including sell-side and alternative research providers.

In fact, prior to 2000, most buy-side firms relied on external research (particularly the research produced by the sell-side) for a whole host of reasons, not the least of which is the fact that using bundled sell-side research meant that they could finance this through client commission dollars, rather than paying for their research out of their own fees.

The Sea Change Begins

However, this all started to change in August, 2000 when the Securities and Exchange Commission adopted Regulation Fair Disclosure (“Regulation FD” or “Reg FD”) aimed at curbing the selective disclosure of material nonpublic information by public company management (corporate issuers) to analysts and institutional investors.

While large brokerage firms generally opposed Regulation FD based on the fear that it would lead to a chilling of the information flow from issuers to the marketplace – the real impact of Reg FD was that overnight, it eliminated the single largest competitive advantage of sell-side or investment bank research departments.  Consequently, buy-side firms started questioning the importance of sell-side research and wondering if they could not produce much of what the sell-side previously produced internally.

Of course, the second shoe dropped on April 28, 2003 when the SEC, the NASD, the New York Stock Exchange (NYSE), the National Association of State Securities Administrators (NASAA), and the New York State Attorney General announced the final terms of the Global Research Analyst Settlement.

The Global Settlement followed joint investigations by the regulators into alleged conflicts of interest caused by the over reaching relationship between investment banking departments and the securities research published by those investment banks.  As a result of the investigation, ten of the nation’s top investment firms agreed to pay $1.4 billion in penalties and restitution. The firms have also agreed to reforms in the way they do business to help prevent these conflicts in the future.

The high costs of reforming the way they produced their research, combined with the bursting of the technology bubble in 2001, prompted many sell-side investment banks to dramatically reduce the number of domestic stocks they covered in the past five years.  As a result, many of the country’s largest buy-side institutions have been forced to make up for this coverage shortfall by increasing the number of stocks covered by their own research departments.
Unbundling and Commission Transparency

It many ways, the unbundling and commission transparency trend that has started developing in recent years should be beneficial to the buy-side as this enables institutional investors to purchase “best of breed” execution and research services separately.

However, some money managers may not like how their customers respond to the bright light of commission transparency.  In fact, a small but growing number of asset managers have expressed concern that a client base with more information about how their commissions are being spent might start to question why their managers are spending so much on external research.  After all, these clients might start to wonder what they are currently paying their money managers for?
As a result, this fear (or the very real pressure from customers) could spur the larger buy-side investors to continue investing to expand their internal research staffs.

Our Outlook

The team at Integrity expects that all of these trends; the questionable value of sell-side research, lower coverage universes, and client demands for self reliance will prompt the buy-side to continue investing a significant sum in people, technology and processes to expand their internal research departments.
However, it must be understood that not everyone on the buy-side will behave in a similar manner.  In fact, we suspect that large fiduciary managers will be the most likely to expand their research departments as they will have the economies of scale to do so.  Small and mid-sized money managers will not have the financial wherewithal to invest a significant sum into their research departments.

Hedge funds, on the other hand, will not have the same competitive pressures to invest in their internal research departments – though some may decide to do so if they are targeting the pension fund market, rather than the high net worth business.

The Consequences of this Outlook

Interestingly, the fact that the many buy-side participants will continue expanding their internal research capabilities is one reason we have a constructive outlook for a segment of the alternative research space – particularly primary research, and the more innovative tools, proprietary data, and analytics providers.

In addition, we also expect that the only way that mid and smaller asset managers will be able to compete with their larger buy-side brethren will be through the use of sell-side and alternative research.

Comment by Bill George:
This article mentions that the trend toward commission unbundling and transparency will allow investment advisors to buy “best of breed” execution and research services separately. This article also seems optimistic about “the trend” toward client commission disclosure and transparency and it expresses optimism about how such disclosure and transparency will create de facto unbundling. The article also mentions that some advisors fear that “a client base” with more information about how their commissions are being spent might start to ask more questions about those expenditures.

I don’t share this optimism. That’s why on February 10, 2007 I filed a Request for Rulemaking on Disclosure and Transparency in Client Commission Arrangements with the U.S. Securities & Exchange Commission (see file 4-531). Without a well defined regulatory mandate specifying the minimal standards of disclosure and transparency the observed trend toward disclosure of brokerage commission arrangements can end at any time.

Most institutional account owners (clients of mutual funds, personal trust account owners and pension plan beneficiaries) assume that their fiduciaries are providing oversight of their brokerage commissions and management fees; they have trusted that these fiduciaries interests’ are aligned with their interests. For some reason these institutional clients maintain this belief in spite of the scandals and the constant drip of news articles describing investigations, prosecutions, and settlements for institutional investment advisors’ use of there clients’ commissions to pay for “services” that violate fiduciary responsibility and the concept of direct benefit. So far, I don’t see significant pressure from institutional clients or their fiduciaries as being a major impetus for commission disclosure and unbundling in the United States.

I believe that Commission Sharing Arrangements (CSA’s) and Client Commission Arrangements (CCA’s) have raised the steaks in this discussion. The steaks have been raised because there is an anecdotal belief* that a few large full service firms provide “best execution” and because the consensus opinion is that, under CSA’s and CCA’s, most institutional investment advisors will concentrate their order flow at a few large full-service brokerage firms. It appears that the beneficiaries of this order-flow concentration will be the same full-service brokerage firms that have always claimed that they cannot provide commission disclosure and transparency for the services provided in their bundled services brokerage arrangements. I believe any trend toward brokerage commission disclosure and transparency will abate at the same rate CSA’s and CCA’s are implemented. It seems odd that regulators accept the claim that full-service brokers cannot provide commission disclosure even as full-service brokers try to defend themselves in conflicts of interest prosecutions where bundled commissions have provided “cover” for the exchange of clients’ brokerage commissions for a variety of favors which don’t benefit the client.

* I say anecdotal because I haven’t seen any credible transaction cost studies that claim to have conclusively found that best execution is more probable at large full-service brokerage firms as compared to third-party institutional brokerage firms.

For more on CCA’s see SEC “No Action Letter” concerning commission sharing under the Research Xpress model.

Comment by Rob Tholemeier:
My cynical, but firmly held opinion, is that what Reg FD did was cut out the middleman (i.e. sellside research). Now companies that leak (and this is more common than most people think) is direct from the insiders to the institutions.


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