Transparent Bundles Part III

How is research distributed?

Is it embedded in the trade solicitation?

Or is the idea distinct from how it may get traded?

Why is this important to begin with?

I would argue that the essential value of wall street lies in the location of where the buy side accepts external ideas as a part of its investment process. To a great extent, the buy side has all of the tools at its disposal to do its job, without aid from the traditional wall street brokerage house. The trader at the fund has 6 screens and can monitor pools of liquidity and place trades seamlessly. The virtues of anonymity, transparency, liquidity can all be addressed by technology just as easily as they can by a human sales trader. Some large complicated trades may still require human ingenuity to break up and place properly, but these too will become easier to manage through technology than individuals. Even flow, the near-sublime quality of a human trading desk has become simulated through syndicated web sites, and message boards .

So from a trading perspective it becomes more and more dubious why to pay anything more than the bare minimum ($.004/share maybe for now). To the extent that humans will be required, their skills are such that they will be easily exported to emerging countires at a fraction o the cost.

This may take years, not months, but it is inevitable. Financial markets have an endless appetite for technology solutions and business models that help automate their operations.

If trading becomes a commodity, then one has to look at the other products and services of the sell-side to justify their economic position. Besides trading, it would seem that the remaining values are access to hot issues (IPOs), access to management, conferences, and research.

In terms of hot issues, it seems certain that the allocation of IPOs will come under increasing restrictions by the SEC and the exchanges themselves. Granted, we are entering another bounty of successul public oferings and nasdaq recently eased restrictions on brokers' allocation abilities; nevertheless, Spitzer has demonstrated clearly than any artificial price manipulation benefitting one institution over another (investment banking, market timing, specialist firms, and so on) will come with major penalties for the firms and their principals

Access to management is, after Regulation Fair Disclosure, more of a concierge service than anything else. It's not that different from brokers procuring sports tickets for their best clients, except in this case it's CEOsand CFOs of public companies instead of star 3rd basemen. There is no longer any suggestion that the management content is different based on who is introducing the company to the fund. Simply that management's time is valuable and there are only so many "in person" mtgs they can afford, even if the content is exactly the same as all other meetings.

The buy-side continues to ascribe value to physical contact, over and above any other form of information. Since companies are legally barred from selective disclosure, and understanding how much funds currently value face to face contact with management, we are talking about the most expensive facial expressions this side of jim carrey.

Conferences are somewhat similar, insofar as they tend to be simply opportunities to have multiple "management 1 on 1s" in a single location. The lineup of speakers is interesting, and the collection of friendly buy-side analysts is convenient, but the value again rests in the tics and gestures.

Which leaves us with value of research.

Research as representing the stream of ideas codified in some form of communcation that comes from a sell side firm directly to the buy-side. Of course there are many kinds of research, from the old school of financial models and analyst opinions to the new school of forensic accounting, credit analysis, and access to networks of experts.

Technology threatens to commodify the value of research as well. Smart analysts that attend management meetings, pore through 10K's and produce intelligent analysis are now facing considerable pricing pressure from syndicated management calls, easy access to public disclosure and cheap analytical labor in remote places such as India.

The most successful research firms are those that aren't simply running ahead of the inevitable surge of commodifying technologies, but rather those that figure technology fundamentally into their research process. For example, many expert networks such as Gerson Lehrman's effectively use the Internet to recruit, rank and provide access to experts across the world. The buy-side can to a certain extent bid on this expertise as if they were using Ebay. This is an example of a research product that uses technology to scale insights. To the extent to which it is able to tie the scaling of insights to the generation of trading commissions, then such a firm successfully distributes research in a manner consistent with how the buy side will look to pay for research in the future.

The critical factor that I am struggling to address is why the buy side needs research from the sell side any more than it needs to spend $.05/share to execute trades through the bulge bracket? The economics of a hedge fund are so rich that such funds are able to attract the best and brightest analytical minds to work for them directly. In the past, the sell side was able to subsidize analyst costs through investment banking revenue and so were able to offer folks like Jack Grubman $20M per year. Those days are over, while today a key analyst at a large hedge fund can make more than $1M per year and a fund manager can make 20+x that in a good year.

The solution for the sell side is to come up with products and services that take advantage of its primary focus on research and minimize any consideration of other features such as trading, banking, etc. In the end, the fund is in business to make money trading stocks (or bonds, or commodities, or whatever), so that the fund's internal research will always be a means towards an end but never an end in and of itself. The competition of the sell side is not other sell side firms, but rather the internal research departments of the funds themselves. Every day, the successful investment research firm needs to demonstrate value (in terms of number of experts in its network, or amount of proprietary data, or variety of analytical tools) that grows proportionate to attention and focus. Since the sell-side can't win the war of having the smartest standalone analysts (who will naturally gravitate towards the buy-side for better economics), it can instead emphasize the scale it has achieved in certain areas that a fund will never on its own accomplish (such as building out market research panels, negotiating complex license agreements, cleansing raw data, etc.).

Again, I am talking my position since the company I work for Majestic Research is explicitly trying to take advantage of these changes. What continues to confuse and fascinate me, however, is how the development of these new sell side investment research systems will drive new forms of payment from the buy-side outside of traditional bundled commissions.

The name of this blog is transparent bundles, and by that I am suggesting a means of combining trading and research in a manner than maintains the efficiency and velocity of commission-based compensation while avoiding the shadows and whispers of traditional trading relationships. The MFS rant about soft dollars, Fidelity's scrutiny of bundled commissions, and Spitzer's unyielding assaults on market timing, investment banking conflicts and whatever he comes after next, are all combining to force the need for a "transparently bundled" solution to the forefront of the debate.

Complicating matters even further is the fact that funds are looking to cut down on their trading relationships as opposed to adding new brokers.

Need to do some more thinking on this one and report back when I achieve additional clarity.

Comments

[Brian from NYC]

Since Reg FD doesn't apply outside the US (at least in non-US listed foreign cos) access to management is still valuable because it is possible to get incremental non-public information from the meetings. Also when you operate in the US frequently travelling around the world to meet all the companies you look at can be time consuming. So in this respect the 'consierge service' at least still adds value for international buy-siders.