Hedgies Beat Long-Onlys on Research
November 26, 2007
Despite signs that mutual funds and hedge funds are converging, long-only mutual funds are slackers compared to hedge funds when it comes to using external research.
This is one of the conclusions of a study released by Integrity Research Associates this month.
"Our study confirms that hedge funds are more aggressively seeking out new sources of research than long-only managers," said Michael Mayhew, Integrity's chairman and author of the study.
"Long-only managers are complacent about external research, whereas hedge funds are continuously looking for what's new and innovative," Mayhew added.
Hedge funds review their external research more frequently than long-only investment managers, are three times more likely to seek assistance finding external research and are much less confident that they have already found the best sources of research, Integrity discovered.
The findings were based on a poll of 43 research directors at U.S.-based hedge funds and long-only institutional investors in October. Questions concentrated on how institutional investors source and value external research. Although the study was based on a small sample, results were consistent with hundreds of interviews with industry executives, Mayhew said.
Forty-two percent of hedge funds evaluate their portfolio of research providers at least monthly compared to only 5% of long-only managers. In addition, hedge funds are three times more likely to use external sources to identify research, with 45% of hedge fund research directors employing outside sources, compared to only 13% of long-only directors of research.
Another finding was that 30% of hedge funds were either "not too confident" or "somewhat confident" that they are using the best external research available compared to 18% of long-only managers. Integrity concluded this and other findings indicate that long-only managers are more complacent about their research capabilities than their hedge fund brethren.
Integrity also asked buy-side research directors if their research providers offered unbundled prices as part of their research valuation process. Close to six out of 10, 58%, acknowledged that they did consider if their research providers offered their services on an unbundled basis.
Some respondents said providing transparency to their clients was more important than moving toward unbundling.
Many research directors noted they preferred to pay for research with client commissions, a strategy that forced them to accept a bundled model.
One reason for these results, Mayhew said, is that long-only asset managers are rewarded primarily for gathering significant amounts of assets under management. This asset-gathering function is impacted by the distribution relationships of the firm, the firm's marketing organization, its track record, its relationships with pension consultants and the firm's cost structure relative to assets under management.
Another concern for mutual fund executives is the firm's investment performance relative to its peers and less so in absolute terms.
In all, Mayhew noted that mutual funds succeed or fail on a number of performance metrics besides returns. Concerns such asset collection and the marketing efforts needed to support greater intakes can distract from a more single-minded focus on performance.
Within the fund management industry, Fidelity Investments and AllianceBernstein Investments do a good job of seeking out external research, Mayhew said. In fact, Morningstar recently complemented Fidelity for improving many of its funds' performance over the past year, primarily because of an additional $100 million investment in research.
Fund executives' efforts to improve their outreach for research will be complicated by the fact that there is a philosophy, Mayhew said, in many mutual funds that supports the limited role external research plays at a long-only mutual fund.
But internal philosophy or not, Mayhew said some fund industry executives were stunned when first presented with the study's conclusions. Fund management executives will likely become more demanding about increasing the role that external research plays, he said.
But some mutual fund industry executives found fault with the report. Jeffrey Keil, principal at Keil Fiduciary Strategies, said that because of the differences between hedge funds and mutual funds, to directly compare their research needs "is clearly a disconnect."
He also pointed out that many hedge funds are small and therefore must hire external sources to conduct research provider searches. Keil said that most open-ended funds do not use the exotic and faddish techniques that are allowed by hedge funds, and, therefore, don't need to seek out research to support these strategies.
He also said that "new and innovative" in regard to securities usually equates to untried, untested, complicated and illiquid.
Another mutual fund industry expert, Burton Greenwald, president of B.J. Greenwald Associates, said he thought the report's conclusions were "dubious, at best." A comparison between mutual funds and hedge funds is difficult, Greenwald said.
Mayhew said the adaptation of hedge fund-like strategies, such as 130/30 funds for long-only mutual funds, could be a learning experience for mutual fund managers. The increase in strategic choices could lead to executives switching emphasis toward competing on performance rather than concentrating on distribution and asset-gathering skills, he said.
But, Mayhew noted, all asset managers aren't rushing to embrace new research sources even if they have diversified their product lines beyond long-only. "As long-only managers introduce more alternative products like 130/30 funds, they are talking the talk, but our survey suggests that they are not walking the walk," Mayhew said.
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