New York, NY – The move to commission transparency in the UK, and the increased clarity around the definition of, and allowable use of, soft dollars in the US in recent years has created a growing need on the part of institutional investment fund directors and boards to understand how their client’s brokerage commissions are being used.
Historically, most investment fund directors and boards had limited information on exactly how institutional commissions were being used, as bundled commission arrangements obfuscated exactly what services their clients were receiving (and how much they were paying) for the equity commissions their managers were paying.
However, the development of increased commission disclosure has created an environment where pension fund directors are starting to ask important questions on behalf of their investors. In recent years, boards have been concerned that their investors were getting “best execution”, hence the development of numerous TCA systems.
Now pension fund directors and mutual fund boards are starting to ask the next most obvious question — and that is, “Are my clients getting best research?”. This includes understanding if their investment managers are purchasing “best in class” research, and are they paying an appropriate amount for this research.
To this end, a number of firms have started developing products designed to help institutional investors assess the quality of the research they receive and determine if they are getting “good value for money” from this research.
One type of system that provides insight into the value of one type of research — trading ideas — has sprung up in recent years. Firms like Alpha Network (purchased by FactSet), the Trading Ideas Network, and First Coverage offer such solutions. In addition, research performance management systems, like those offered by StarMine or Investars have developed some traction with the buy-side. Commission Allocation Systems from firms like Cogent Consulting, Eze Castle, or Financial Sockets also provide significant value in addressing these issues. More recently, a new category of service called Research Management Systems, have sprung up which also help investors leverage and value their external and internal research. Code Red, Tamale Software, and Research Wave all provide some form of Research Management System.
Each of these systems, while immensely useful in helping portfolio managers, hedge fund managers and buy-side analysts address various aspects of the research quality / value problem, few if any of them address the entire issue.
First, the “quality of research” is based on a number of factors including the experience of the people producing the research, the uniqueness or proprietary nature of the products, the scarcity of the insight, the crediblty and trustworthiness of the firm and its compliance procedures, as well as the performance of the ideas, or the number of management meetings and conferences provided.
Alpha Capture and Research Performance Measurement systems help the buy-side measure the returns of a research firm’s trading ideas, earnings estimates, or recommendations. However, these systems do very little to address the quality of a firm’s analytical insight, management access, or access to analyst models, let alone measure the quality of “non opinionated research”.
Commission Management Systems and Research Management Systems help buy-side institutions value the research they use on a relative basis. Unfortunately, these systems do little to help PMs or analysts determine if they are using the best external research providers as part of their investment processes.
In addition, none of the systems that currently exist have been able to truly address the conundrum of “research value”, which includes BOTH the quality of the entire research offering AND the price paid for that research.
In other words, a firm may agree that Research Firm A’s service is extremely useful, but is it really worth $2.0 million per year? This question that is particularly difficult to answer when their is little price transparency in the marketplace. This also doesn’t address the question whether there are research services that have higher “value” with quality that is almost as high, but that might have a lower price.
Based on our study and analysis of the marketplace, these extremely complex “research valuation” issues have yet to be addressed by any one provider. But this doesn’t mean these systems aren’t useful in helping clients make informed purchase decisions. Ultimately, the information provided by these systems needs to used as a part of an overall research assessment and evaluation process.
NOTE: Integrity Research Associates provides comprehensive research identification, assessment, and evaluation services to mutual funds and hedge funds.
A related article was recently written in the July 10, 2007 issue of BoardIQ (www.boardiq.com) titled, Products Pave Way for Greater Soft Dollar Transparency. A regular ResearchWatch reader, Mr. William George wrote an interesting response to this article, which we have included below.
The July 10, 2007 issue of BoardIQ has an interesting article titled, Products Pave Way for Greater Soft Dollar Transparency by Beagan Wilcox (www.boardiq.com). This article describes how some investment analyst performance ranking services and some research effectiveness measurement services have begun marketing themselves to fund directors, mutual fund boards and other institutional investment fund directors and boards. These rating and ranking services apparently are claiming they can provide great insight into the appropriate uses of institutional clients’ brokerage commissions.
After reading the article a couple of times, I’ve come to the conclusion that because of this marketing approach, institutional investment advisors, traders, and broker dealers need to prepare themselves for the kinds of questions that such simplistic approaches to measuring the value of investment research seem guaranteed to generate.
First it seems extremely important to emphasize the point Wayne Wagner made toward the end of the article. That is, trained investment professionals managing institutional portfolios don’t make investment (position) decisions based on the buy, sell, hold, recommendations from full-service brokerage firms’ analysts. Trained institutional investment professionals want to see, and validate, the detailed analysis that produces the recommendation. (One word investment recommendations are retail brokerage “bait”). Professional investment managers scour the detail of the full research reports and glean information from the more detailed analysis of company financials and the analysts’ assessments of management, products, marketing and other factors; as discussed in a complete research report. Professional investment managers test and validate the information in one research report against other detailed research reports and they use their training, and in-puts from other sources and from proprietary resources to develop their own conclusions based on these detailed in-puts and their evaluation of them.
Second, it seems that companies selling research analyst “rating” services ignore at least one very important dimension of institutional market activity. That dimension is time. Investment research analysts’ reason for being is to find investment opportunities the market has valued incorrectly. Once those investment opportunities are discovered an investment manager must implement an acquisition or divestiture program that allows the manager to capitalize on the information advantage. In institutionally dominated efficient markets it’s very difficult to implement a “position” trading program without exposing information to the market. It seems to me that quarterly investment research ranking statistics often only highlight the popularity of the analyst or the strength of the marketing network and the size of the analyst’s firm’s client base (let’s call it the Blodget – Grubman effect).
And, I have a third concern about depending too heavily on research analyst rating services as a monitor of excess client brokerage commission payments (paid above the costs of execution). My third concern is that the implementation and the diligent management of institutional sized equity positions can only be accomplished with good day-to-day market insight and intelligence. The buy-side investment manager and his traders must receive market intelligence reports from sell-side traders. Buy-side firms compete between each other for “first-calls” and for up-date reports on “market-color” and issue liquidity. They want reports on the broad picture and on the specifics on portfolio holdings and securities of interest. Such market intelligence is research, and the buy-side trader who doesn’t compensate his sell-side counterpart for her / his extra effort will soon loose her / his eyes-and-ears on the street.
It seems fiduciaries are becoming more sensitive to their obligation to protect institutional clients’ brokerage commissions and to insure that hired advisors are seeking best execution. And, it seems that automated approaches might be developed to assist fiduciaries in their oversight goals. However, it seems the greatest benefit derived from the approaches described in this BoardIQ article is to provide a preliminary basis for discussion that will improve communication and understanding (between fiduciaries and their hired advisors) of the issues involved in advisors’ uses of clients’ brokerage commissions, and the goal of best execution.
Comment by Bill George:
For those who would like to see the BoardIQ – July 10, 2007 article titled, “Products Pave Way For Greater Soft Dollar Transparency” by Beagan Wilcox – you may want to click this link.