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Fund Firms Bulk Up Research Teams: As Soft Dollars Shrivel, Internal Research Expands

As the soft dollar squeeze forces fund companies to show exactly how they spend their commission fees, they are increasingly relying on in-house research, according to a recent report by Integrity Research Associates.

"Are you going to pay for external research that you can't control, or internal research, which you can control?" said Michael Mayhew, chief executive officer of the Darien, Conn.-based research and ratings company.

Scrutiny of soft dollars by regulators and investors alike following the mutual fund trading and sales practices scandals, coupled with the earlier investment banking research scandal, has some industry insiders betting on the house.

By 2009, fund companies will generate 41% of the research they rely on in-house compared to 26.2% in 2004, according to the report.

This will contribute to a continuing decline in sell-side research, with many following the lead of Wells Fargo of San Francisco, which pulled out of the business altogether in August 2005.

Because not all fund companies can afford to build out their internal research, independent research providers' business will boom. By 2009, independent research companies' market share will expand to 26.2%, up from 15.8% in 2004.

This immediate boom will then be followed by consolidation and fierce competition among independent research providers, according to the report.

"The ultimate survivors will be the firms that produce high-quality, innovative research and have strong sales and marketing capabilities," the report notes.

Demand for all types of research has increased dramatically in recent years. In 1990, approximately 190,000 equity research reports were published by sell-side companies, buy-side fund complexes and independent firms, compared to 1.1 million today.

And it doesn't come cheap. Between 1998 and 2004, retail and institutional investors increased their research spending by 67% with spending in 2004 at $9.31 billion. Integrity anticipates the market to continue to grow, reaching $11.9 billion by 2009.

Fidelity Investments gets much of the credit for making the first move in what seemed to be the increasingly unavoidable problem of separating commissions into transaction costs and services.

Last year, the Boston-based behemoth reached a landmark agreement with Lehman Brothers to unbundle its trading fees whereby the New York brokerage house agreed to execute investors' trades for a lower commission, without providing any research. Fidelity now pays $7 million per year for research from its own coffers, rather than bundled in with trading commissions. Furthermore, Fidelity is now in the process of doubling its internal research department.

The move, a reaction to growing skepticism among investors of fund companies' too-cozy relationship with investment banks, launched an industrywide trend of acknowledging publicly what many industry insiders have only whispered.

"If you want to have a good fund, you've got to have good in-house research," said MFS Investments Chairman Robert Pozen, during an address in Miami last month.

Unlike sell-side research, in-house analysts have no motive to promote companies. Instead, the buy-side analysts' first loyalty is to a fund's performance, and by extension its shareholders' welfare, according to the report.

Some of the bigger fund companies have already begun to rely more heavily on internal research. Between 2003 and 2004, the average fund company increased its research staff by 20%, increasing the number of equity analysts from 8.6 analysts per firm to 10.8. During the same period, industrywide, spending on in-house research increased 32%, rising from $1.85 billion to $2.44 billion.

This puts pressure on medium and small fund shops because as reliable and objective as it might be, in-house research is not always the most cost-effective.

For each company they cover, investment banks and brokerage houses, on average, spend approximately $175,000 per year in research. In the example of Fidelity and Lehman, that works out to roughly two cents per trade, when bundled with execution costs, according to the Integrity analysis.

With commissions dropping to an average of four cents per share in 2004, compared to six cents in 1997, the amount of money banks are spending to produce research is unsustainable, and as a result, banks and brokerage houses are backing out of the business or reducing the number of companies they cover.

What it costs an independent or buy-side company to cover an individual stock is dramatically less, approximately $10,000 per year, according to Integrity. Yet because funds are comprised of so many stocks, a fund with 50 companies is looking at an annual cost of $500,000. This expense could be as steep as 3% of a fund company's overall margin, according to Integrity.

Not all companies can absorb such a hit, the way Fidelity can. "Smaller asset managers would be impacted much more seriously - prompting consolidation by some while others might even be forced to exit the business," the report warns.

In the near term, independent researchers can capitalize on the increased demand, according to Integrity, which expects the amount of money spent on independent research to double within the next five years.