How hedge funds should respond to the sell-side research problem

Summary: Since the value of research diminishes the wider its readership, research firms need to rethink their business models, and hedge funds and mutual funds need to cultivate new sources of data and analysis.

The enforced separation of investment banking from equity research last year exposed a fatal flaw in the research business. Investment banks' research departments were once subsidised - perhaps even majority funded - by investment banking business. Companies would select investment banks for their IPOs and secondary equity offerings at least partly on the prestige of the analyst that would cover their company. And the investment banks would respond by rewarding their research analysts with a cut of their investment banking fees. That practice has ended, thanks to Elliot Spitzer.

Equity research now has to be funded entirely by revenues from those who use the research - hedge funds and mutual funds. But here's the problem. The equity research business is inherently non-scalable. How so?

Good equity research is only valuable if few people know about it. The more people who see a research report at the moment of publication, the less valuable the research is. If a large investment bank publishes a research report before market open that proves conclusively that a stock is overvalued, and the research is read by clients who control a reasonable proportion of the stock's float, the stock will open lower before a single client is able to trade it. In an efficient market, widely disseminated research is literally valueless.

Don't think this problem is purely theoretical. If you are a sell-side research firm there are 3 practical implications:

1. Don't try to scale your research business beyond what is reasonable. Understand that if you continue to add limitless clients, you debase the value of your own research.

2. Pick your clients carefully. If your business can only sustain a limited number of clients, you'll need to pick the most profitable clients and focus on them.

3. Don't allow free-riding. Fight hard to prevent your research being circulated to people who don't pay for it, particularly via email. If your client base is inherently limited, every new "client" who doesn't pay costs you money.

What's the message for hedge fund and mutual fund managers?

Individual investors and funds of funds will increasingly evaluate hedge funds on the uniqueness of their research sources. Fund managers who want to generate alpha will have to find little-known sources of data and analysis.

My personal view, having been a sell-side technology analyst, is that funds need to rethink their approach to research. The Internet should help create a market where purveyors of industry knowlege and expertise can more easily make contact with fund managers. The growth of blogs also means that information is now available on the Web that is potentially useful - but untapped by institutional investors.

This is the rationale behind two resources on SeekingAlpha.com. First, I've established a free message board for anyone who wants to provide research, data or consulting to hedge funds. Over time, I expect this message board to be populated with information about individuals and firms whose work gives them the insight that hedge funds would find useful - such as doctors with expertise in new medical technology, systems integrators monitoring demand for technology products or retailers with information about consumer demand for particular products.

Second (and less importantly), I've compiled an annotated listing of financial blogs. In some cases, these blogs provide new sources of information and perspective, yet most hedge funds and mutual funds have not yet discovered them. The strongest blogs tend to be the economics blogs, the weakest the stock-market blogs. The list currently includes about 35 blogs; I plan to update it regularly.