New York, NY – This past Friday at the Grand Hyatt in New York, AQ Research and Integrity Research Associates co-sponsored an extremely successful conference on CSAs, unbundling, and research called Navigating the Research Marketplace. This year’s keynote speaker, Harold Bradley, was the former CIO of American Century Funds and is the current CIO of the Kauffman Foundation. 

Mr. Bradley shared a number of ideas with the audience around the topics of soft dollars, unbundling, commission transparency, and the future of research in his speech called Sharks in the Water – the future of 28(e).  The following are a few of the ideas offered by Mr. Bradley.

Fund Directors Increasingly Concerned…

One of the initial themes Mr. Bradley expressed was his contention that, for a number of reasons, independent Mutual Fund Directors were becoming increasing concerned about the lack of transparency that currently exists at many buy-side firms.  Bradley explained that three of the main ideas that are becoming important to Fund Directors, include:

Protecting Other Peoples Money:  Bradley acknowledged that Fund Directors were becoming more aware that their roles required that they do everything they could to maintain investor trust and credibility.  This concept of being good stewards meant that Directors needed to require more from their funds than was legally required.

Abuses Threaten the Reputation of Firms: Bradley also noted that one of the main developments that have pushed Fund Directors to become more active was the series of scandals that have rocked the financial services industry in recent years.  This includes mutual fund late trading, the Fidelity “dwarf tossing” incident, and various T&E abuses that have been publicly reported.

Trends Require that Directors Demand Accountability:  Bradley also explained that various regulatory developments were sending the clear message to Fund Directors that they needed to develop a climate of accountability.  This, he felt, would require that Directors, require increased transparency, as well as establish processes and measurement systems to validate their decisions.

Buyside Defends Use of Commissions to Pay for Research

Bradley, however, was realistic that the buy-side would aggressively defend their use of client commissions (soft dollars) to pay for proprietary and independent research.  He explained in significant detail how important this was for money management firms to maintain their operating margins at or above 30%.

However, Bradley thought that it would be a good idea if the SEC mandated that money managers report their commission rates for execution services for each broker, thereby making it clear how much these managers were spending for “other services” from these brokers, including research. 

Many Will Demand Reports to Validate that Research Spend is Reasonable

Mr. Bradley also felt that many mutual fund directors would start demanding that their funds create systems that could generate reports that would quantify and validate that the amount of commissions being spent on research was “reasonable” in light of the vale of products and services provided by the broker dealer.  He acknowledged that the SEC required that money managers make this determination in their July 2006 interpretive guidance regarding client commission practices.

Fund Directors May Require Measurement of Research Value

One theme that Mr. Bradley spoke about quite extensively was that he expected that some fund directors might demand that systems be developed comparing a buy-side firm’s commission flows with both an objective and subjective measure of the value of various research services they used.

Bradley himself pointed out various systems that provided some help in this area including systems from StarMine, Investars, and CodeRed.  Bradley even mentioned that Integrity Research provided research evaluation tools that might be useful in this regard.

Two ways that Bradley thought could be used to measure research value was to control and count research report readership, and to objectively track and calculate the performance of analyst recommendations and estimates.

Bradley did note that the implementation of systems to measure the value of research was not without cost.  Not only would these systems be costly, but they would eliminate the flexibility associated with the current opaque system where money managers reward brokers based on more subjective factors including the value of the relationship, the client support, judgment and insight, etc.

However, he did note that the cost would be outweighed by the fact that money managers would have this data if ever asked by regulators or their fund directors to produce it.

Additional Regulatory Clarity Required

Bradley also discussed his view that he expected the SEC would still need to provide additional guidance on soft dollars – particularly around disclosure and commission transparency. 

In this regard, Bradley noted that some on the Commission privately supported his contention that an industry wide “execution only” commission rate needed to be collected and disclosed, thereby enabling investors and fund directors to impute exactly how much asset managers were spending for other services, including research.

Of course, Mr. Bradley explained that many of his colleagues in the money management industry continued to complain that they could not measure the value of services in an unbundled world.  Bradley noted that this argument was not sufficient and that buy-side firms needed to develop these types of “research value measurement” systems.

Who should pay for Independent Research?

One additional topic covered by Mr. Bradley in last week’s conference was his view of how independent research might be paid for in the future.  Bradley argued that given various trends like the increased use of electronic trading systems and dark pools, and the fact that most sell-side profits are coming from principle trading, and not client commissions, that the current commission supported research business made very little sense.

In fact, Bradley argued that the entities that might have the most economic incentive to support independent research in the future was the exchanges themselves as they needed to develop a new value proposition to attract new issuers and investors in these stocks. 

In this regard, Bradley thought the exchanges might want to pay for research coverage from the best analysts in relevant sectors and distribute this research to investors.  Bradley also noted that some broker-dealers might choose to aggregate “star players” in the independent research space as a way to grow their commission revenue.