The Payment Paradigm

In this weekend’s New York Times, Joe Sharkey wrote an article titled ‘The Skies Are Alive With Fees,’ which points out some of the payment adjustments and ‘unbundling’ of services that many airlines are undertaking in order to generate revenue. Since most passengers have been conditioned to pay in a more conventional, ‘bundled’ manner for flights, many are immediately skeptical of this new payment model – even though at first glimpse, it does seem to make sense and have some advantages.

After all, wouldn’t you rather pay for what you want, than pay for ‘perks’ you have no interest in or have any intention of using?

We point to the airlines’ new payment models, because it draws an interesting parallel to the current payment transition in the investment research world. As the SEC this past week has proposed rules that will require further disclosures for soft dollar transactions, different payment options that simplify payments for research services will become a more common part of the equation. Despite the growing popularity of flat-fee type payments for research, many portfolio managers (PMs) seem to have a difficult time embracing the idea of paying for research as a full product, rather than paying for each individual idea (through trade commissions). However, as time ticks down for the SEC to fully implement new disclosure rules, flat fee payment for research will seem like a far more desirable option. Disclosing a flat fee payment for research services will minimize compliance confusion and bookkeeping nightmares.

As with the airlines, it will also become attractive to portfolio managers and investors to buy the research they use and want, rather than paying for ‘add on’ research that delivers no value.

For independent analysts, the shift to a model where they can be compensated for full access to their insights, rather than solely for specific ideas, means that they are finally getting some of the respect – and compensation – that they deserve. PMs also benefit, because by essentially having fractional ownership of the analyst, they are able to access the insights of an analyst whose insights they trust, at a fraction of what they would pay to put that analyst on their staff. The SEC is creating a win-win situation by taking steps that benefit analysts who generate actionable ideas and the portfolio managers that use/need them.

There was a lot of resistance to the internet when it was first born, too, and people who were used to handling their business and information gathering in other ways had a hard time adapting…but before long, it was widely embraced because the advantages were indisputable.

If perks to flat fee payment are implemented – such as selling the research solely on a limited distribution basis, and making the analysts accessible as an extension of the PMs own research team, independent research providers with payment models like StreetBrains’ will prove to have indisputable advantages over the conventional model, too.

Lessons Learned From Sporks

If you made it through elementary school, chances are, you’ve used a spork at some point in your lifetime. Upon introduction to this odd tool, you likely thought to yourself “in theory, this makes a lot of sense.” After all – why have two separate utensils when you can just have one?

But as you moved on through life, this tool seldom reemerged. It seems that most people preferred to have two separate utensils, each to be used at the appropriate time and for its designated purpose, despite the convenience of the bundled item. Apparently, the multi-use tool often proves not to perform either of its jobs as efficiently as the separate utensils.

And therein lies the key differentiator between success and failure of bundling. The services or items bundled must produce equal or enhanced quality performance than the a la carte items or services.

Why are we talking about sporks?

The spork is a fitting parallel to the ‘bundling’ of execution and research that takes place in the financial industry – while it makes sense in theory, it fails in practice.

Like the spork, neither function is able to deliver optimal performance in the bundled model, and therefore, the bundled model is flawed and unsustainable. Like a TV with a built in VCR, the convenience and seeming practicality is undercut by the problems that occur when one of the bundled pieces or services fails. Upon failure, the entire system needs to be replaced, and worse, it can be difficult to assess which piece actually caused the issue so that future problems can be avoided.

The bundling of execution and research has the same inherent problem. Consider this:

Joe pays $.03 a share for execution, despite the fact that best execution pricing could get him execution for less than a penny. But Joe gets research as an ‘add-on’ because he pays $.03 a share, so he pays more for the ‘bundled’ service.

But now, Joe’s paying outrageous fees for minimal returns, and he doesn’t know why so he can’t figure out how to fix the problem. Is he paying too much for execution? Is the research he’s buying poor quality so it isn’t delivering trade ideas that will generate great returns? There’s no way to tell, because the services are bundled together, therefore masking which piece of the bundled product is the source of the failure. This is a detrimental disservice to Joe – and to all investors.

The UK has already implemented requirements for execution and research to be unbundled. It is still unclear whether or not the US will implement similar rules, but hopefully the SEC will acknowledge the inefficiencies that occur in the bundled model. Many firms are taking the shift in the UK as a cue that similar requirements will be imminent in the US, and are using this as an opportunity to offer more transparency to their investors.

More…ehem…’Shortcomings’

In case you’re curious, here are some other bundled items that seem practical in theory, but never quite made it big:

Smell-O-Vision (movies with scent) http://en.wikipedia.org/wiki/Smell-o-vision
Flowbee (vaccum/haircut system) http://www.flowbee.com/
Umbrella Hats http://www.umbrellahat.net/
Windshield-wiper glasses http://www.shadesoffun.com/Nov-CP/wiper_sunglasses.html

Fund Fees: What are you paying for?

It’s probably safe to say that anyone with money to put into a hedge fund doesn’t mind paying a high percentage management fee as long as you’re getting a phenomenal return. It all comes down to value.

Same goes for Manhattan real estate – if a broker shows you your dream townhouse, but you have to pay a 20% broker fee, you wouldn’t blink. You’d be ecstatic that you could stop sifting through all of the unsuitable apartments, and the value of finding what you’re looking for would justify the expense attached to finding it.

In both of these scenarios, the ends justify the means. Unfortunately, for less risky investments, the returns are not high enough to eliminate the question:

What are you paying for?

In the case of mutual funds and pension funds, which, by design, are not typically risky investments, of course the rewards are not usually as exponential as might come from a hedge fund investment. Yet, they have more hidden fees attached to them than Paris has boy-toys. The lack of transparency in fund administrator services and 12b-1 fees as well as management fees, loads, expense ratios, turnover rate, taxes…goes on and on.

(Is your head spinning yet?)

The unbundling initiative that is being largely lead by the independent investment research world would likely help alleviate some of these incurred costs, while also putting money back in the pocket of the Portfolio Managers (PM).

Say what?

That’s right. The guy making you money, should make good money. No one disagrees with that statement. His management fee – if he’s made you 30% this year - is a non-issue. The part that should be called to question is – what other fees are you paying that are unjustified, or being billed to you for unused or under utilized resources?

Like that $150 gym membership you pay each month to have access to something you don’t use – at some point it’s time to reassess the fees you pay and ask: What exactly am I paying for?

Bundled research – the research provided as an ‘add on’ to execution - falls into that camp. This research is often redundant, lacking of value, and gets as much use as your dormant gym membership. Yet it continues to be purchased because it is as common practice in the industry.

Part of the reason this cycle has yet to be broken is that PMs fear unbundling would create more work for them. Though it may take some work on the front end to seek out the top providers for execution and research, respectively – the pay off on the back end of having insightful, actionable research on one hand, and best execution on the other would alleviate headaches for both PMs as well as investors.

The clock is already ticking for PMs to jump on the unbundling bandwagon. Regulators are taking a look at how unbundling can help paint a much clearer picture of incurred fund fees and now it’s only a matter of time before requirements are enacted here in the US as they have been in the UK.

Unbundling could potentially revolutionize the way that funds do business, and bring in some serious revenue for those who embrace it. In a business where being late to the game can cost you everything, we think we will continue to see firms jump on board the unbundling bandwagon.