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.
