Why fund managers should stop over-paying for sell-side research

Why does the sell-side get paid so much for research, in the form of bundled trading commissions?  Hedge fund and mutual fund managers are massively over-paying for sell-side research, given its limited value.  They need to stop paying so much, and save the commissions for their clients.

Here’s the core of the problem: the structure of the research market has been transformed in four ways over the last few years, but the sell-side hasn’t responded:

1. Reg FD (Fair Disclosure) means that sell-side analysts have lost their protected position as conveyors of information from company managements to investors.  That means that sell-side research analysts have to get information the same way as everyone else – by doing real research.  And it also means that those big, expensive conferences for clients of sell-side firms aren’t allowed to be truly useful.

2. The severing  of research from investment banking (thanks to Elliot Spitzer) means that sell-side analysts can’t get unique information before a company goes public.  That information used to be the foundation for a long, privileged relationship between  the analyst and the company.  And the due diligence performed by an analyst would also provide other sources of unique information; but now that’s gone too.

3.  The budgets of research departments have been hit by the severing of research from banking.  Research analysts can no longer get paid as a direct function of an investment banking relationship.

4. Downward pressure on trading commissions is also threatening the funding of sell-side research departments.

How has the sell-side responded to these changes?  Answer: Not very much.  Sure, budgets have been cut and departments reduced in size.  But the way research is done hasn’t changed:

* Sell-side analysts haven’t organized themselves to gather information efficiently, for example by increasing the number of junior data gatherers.  Instead, the sell-side behaves as though it still has privileged access to all that pre-Reg FD information. 

* The sell-side hasn’t admitted that the four functions necessary to produce real stock research – information collection, processing, presentation and marketing – cannot be performed by one highly paid analyst plus an associate.  How can you generate real research if you spend half your day on the phone with clients? 

* Sell-side analysts still write research as though it was for investment banking.  They write thick reports that rehash company filings, but they fail to focus on the factors at the margin that actually move stocks.  How many times have you read a sell-side report that actually addresses the question: What expectations are currently priced into this stock?  If you can’t answer that question, you can’t hope to generate relevant research. 

* The sell-side has stubbornly stuck to the star analyst system.  Because sell-side research departments fail to structure research in data-gathering and processing teams, fail to operate in global teams, and fail to pool information across industries, they confine their analysts to blind silos.

Why do I write this now, almost two years after leaving the sell-side?  Because last week I led a panel on “The Evolution of Research