Small Fund Firms Grapple for Research
June 25, 2007
NEW YORK-Changes to how small and mid-tier asset managers obtain research may be coming, as soft dollars continue to be scrutinized and execution costs are being unbundled, according to panelists at an AQ conference, "Navigating the Research Marketplace."
In the past, research has been viewed as cheap, but that notion is changing. "No one ever bothered to measure the value of research, and no one knew the implicit cost," said Harold Bradley, chief investment officer at the Kauffman Foundation.
There are a few trends occurring as to how smaller asset managers will get research. One is that they will build their own in-house research team. Another is that they will increase their use of independent research shops. But because of asset managers' move to become self-reliant at research, some independent research houses will fold or merge, said Michael Mayhew, co-chief executive officer of consultancy Integrity Research Associates of New York.
Smaller asset managers are following in the footsteps of larger asset managers, such as Boston-based Fidelity Investments, which has been building its internal research team for some time. Fidelity stated last year it hired 90 stock analysts in 2006, and as of last November it had 300 equity analysts and 90 who followed fixed income markets.
"This is something the larger asset management companies have been doing for a while, and the trend is growing for mid- and lower-tier buy-side managers," said Charles Gepp, global head of research at Reuters| of New York.
An advantage of in-house buy-side analysts is that their first loyalty lies with the funds' performance and they have no motives to promote companies.
A major reason smaller asset management firms opt to build internal research teams is that it is becoming increasingly difficult for them to strike deals with brokerages, as smaller companies are not as profitable and do not have the commission dollars similar to the large companies, panelists agreed.
Trading costs often change broker to broker, and smaller fund companies have a hard time getting as optimal a rate as large asset manager, panelists noted.
Also, it is a lot easier for analysts to obtain information on companies than it was years ago. Today, company web conferences are open to everybody, and analysts can go back and read transcriptions at their leisure, Bradley said. Company websites provide a lot of information, as well, he said.
The decision does not come without challenges, as internal research teams are not very cost effective, panelists observed. The question of whether to build or buy research is an economic one, Mayhew said. Small and mid-size fund companies must first determine whether they can hire enough analysts to supply adequate information for portfolio managers, he said. Often, they discover that they have to hire a lot of analysts to make a significant difference, he noted.
Another major factor making it difficult to build internal research teams is that buy-side analysts are now demanding more money because of the active hiring patterns at the large fund companies, Mayhew said.
"In-house research is not exactly practical, as asset managers have to hire analysts to follow every stock," said Gregory DeSalvo, chief operating officer of global active equity trading at Goldman Sachs Asset Management.
A big disadvantage of internal research teams is that they increase operating costs and erode margins, Gepp commented. In the past, fund companies have bundled research costs in with trading commissions, thereby transferring much of the costs to investors.
So, while some smaller asset management shops are building internal research teams, others are turning to independent research shops. The independent shops are able to offer unique, valuable information that is not as readily available to everyone as sell-side research, panelists noted.
However, many independent research shops, through arrangements with brokerage firms, are paid in soft dollars, and this could pose a serious problem for smaller fund companies, since Securities and Exchange Commission Chairman Christopher Cox has called to eliminate soft dollars.
If soft dollars were banished, mutual fund companies and money managers will have no choice but to pay for research externally in cash or build their own teams. As a result, this could potentially hurt investors, as "we suspect that money mangers will have an incentive to raise their management fees to cover these higher costs of operations," Mayhew recently attested on his blog.
Nonetheless, panelists agreed that soft dollars will most likely not be eliminated, and commission-sharing agreements will likely increase.
For the numerous smaller companies that do not have the assets under management to build in-house research teams or pay for research from independent research firms, they may fold or consolidate with other fund companies, panelists concurred. Small funds may not be able to effectively absorb costs, which could lead to greater industry consolidation, Gepp said.
However, not all agree that smaller players in the fund industry are going to consolidate. "Consolidation makes sense from a liquidity standpoint, but from an investor standpoint, it makes no sense at all," Bradley said. More assets under management do not necessarily bring in more money, and what scale used to mean in the past has changed, he commented. Some of the best returns are from small managers, he added.
Furthermore, in the future, as transparency in the industry increases, research will be examined more in depth, speakers said. Fund directors will start insisting on an objective framework regarding research, will want to know its value-add, and evaluate commission flows, Bradley said.
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