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.

I Want it All, and I Want it Now!

We know them as the men who collect Ecosse Titanium Series Motorcycles, Bugatti Veyrons, Ferraris and Aston Martins. Men who spend over $500 million on their art collections, and $12 million on tiger sharks encased in formaldehyde. Men with temperature-controlled wine cellars containing chronological libraries of Romanee-Contis and Chateau-Lafites – many well past their drinkable stages. Men who shop for trinkets for their wives and mistresses at Harry Winston and Cartier, and buy Richard James suits and Charvet shirts for no reason other than they can.

The men described above are covetous. They exude a sense of entitlement. They expect to be granted access to the best of the best the world has to offer – and they hold out altogether until those demands are fulfilled. Many of these men, as you might have already guessed, are hedge funders. Creators of their own fate, their sense of entitlement is earned, not given. These men “eat what they kill” so to speak, and they work tirelessly to ensure that doors swing open for them. They strive for excellence, deliver it, and expect it in return. “Work hard, play hard” was coined to describe men like these. With Veruca Salt-like determination, they want it all, and they want it now, and they simply will not take “no” for an answer.

Understanding the mentality of a (successful) hedge funder in his natural habitat (as above) is a critical component to building a business that exists to serve the needs of a hedge fund.

Make no mistake - despite the tongue-in-cheek Veruca Salt comparison, we are not faulting these men for insisting upon the best of everything. In fact, if they did not have a 'want it all, and deserve it' mentality, they would not be as successful as they are. We do submit, however, that many people have a misconception about this rare breed of personality, and how to effectively work with and appeal to their attitude and behavior.

Demand Drives the Market. No, Demands Drive the Market

Yesterday, Cheyenne Morgan of Advanced Trading wrote a story entitled “Customize My Dark Pool.” (click here to read the full story.) We bring up the mentality of a hedge funder today because after we read this story, we realized that many companies and people marketing to hedge funds may not truly grasp their audience, or simply don’t have the capacity or business model to be able to comply with a hedge fund’s needs and demands (while still remaining compliant with regulators).

The story points out several key ‘buzz words’ that properly describe what hedge funds look for in just about anything that they bother with (no different than how they operate in their personal lives): “Premier.” “Exclusive.” “Unique.” These qualities are of utmost importance to the hedge fund audience. However, first, a business needs to assess whether or not their model can support this limited type of access that hedge funds look for to begin with.

In the case of dark pools (as discussed in the AT article), the jury is still out. While of course it makes sense that hedge funds would much rather pump their trades through a ‘black box’ of trade matching rather than have the whole world try to ride their coattails by having their trade patterns revealed at a larger broker, there is also reason for skepticism when it comes to the allegiances of these ‘dark pool’ offerings.

It sort of reminds us of that girl or guy you might have dated in college, who, you knew had cheated on every person he/she had ever dated, but promised they would NEVER cheat on you – putting trust into a ‘dark pool’ and buying their shtick that ‘you’re their #1 customer’ as they go sing that song to twenty other firms can (and should be) a bit disconcerting. Many seem to be offering ‘security’ out of one side of their mouths and ‘open access’ from the other. Either they don’t know their capacity/capabilities, or they don’t know yet which one sells. If there are clear lines to be drawn that will help hedge funds clearly understand the draw for one dark pool offering over another, the marketing efforts are in need of some bolstering.

StreetBrains had the hedge fund mentality in mind when we developed our model, so we are able to rest easy. We provide limited distribution research and expert access, solely to qualified institutional investors. It doesn’t get any simpler than that, and it’s exactly what hedge funds covet. Unique…limited…premier. Check. Give them what others can’t have. That’s the key.

At the end of the day, whether it’s undrinkable wine, inedible food, ugly paintings or broken statues - value is in the eye of the beholder. (After all, wealth as we know it might cease to exist entirely if the affluent stopped buying $6k Neorest toilets and $15 Renova toilet paper based solely on the fact that other people can’t afford it….)

Expert Networks: Elephant Trap?

According to Integrity Research, “at the end of 2007 at least 26 firms generate between $325 and $375 million in sales by providing expert network services to the buy-side.”

It’s undeniable that the demand for experts of all shapes and sizes has grown exponentially in the past couple of years, and will continue to grow as market volatility drives the need for more information upon which to base trade ideas. Since the implementation of RegFD, it has been increasingly hard for investors to ‘go to the source,’ for any useful/actionable information, so expert networks are a seemingly sensible way for hedge funds and other institutional investors to get a lay of the land without having to wait for company ‘spiel’ to be released.

But, with no real obligation to properly serve the interests of investors, the ‘experts’ – no matter how carefully ‘vetted’ by the network itself – are still not in any way, shape or form, accountable or held to the same standards as a Registered Investment Advisor (RIA). The further these networks expand, the more difficult it will be for networks - and regulators - to keep a pulse on credibility and expertise.

Because regulation of pure-play expert networks is still rather lax, the level of accountability for the experts themselves is minuscule. There has not been a major incident…yet. But if there were to be a major incident today, the information provider (expert) is not held accountable by any standards at all…which should cause investors to proceed at their own risk.

Of course hedge funds and other institutional investors are, by and large, big boys and girls, who should be able to make decisions for themselves about information they find credible and information they do not. But if one of these institutions loses millions or even billions after being mislead (purposely or not purposely) by a so-called 'expert' – who will be to blame?

More Landmines

Beyond the lack of regulatory oversight, there are two other downfalls for pure-play expert networks. The first is that these experts are not exclusive to any one network. So, in essence, these experts could be delivering the same insights to all of your competitors – or worse, in cahoots with the competition. With some hedge funds and other entities choosing to launch their own expert networks, it’s clear that many are not comfortable with the lacking exclusivity that exists in the industry.

The other downfall is that expert networks are a purely ‘pull’ model. What we mean by that is, you have to have the ideas first – there is no dialogue, or anything coming in to you. So, sure, you might wake up this morning and decide that pencil erasers are the next big thing, and you can find a whole range of experts to tell you why they are, why their not, and even put together a custom report outlining how and why – but you have to conjure the notion of pencil erasers as the next great investment all on your own.

At StreetBrains, we believe that the true value of expertise, in any realm, is for experts to offer both ‘push’ and ‘pull’ insights. StreetBrains calls this model the Actionable Information eXchange (AIX.) More specifically – after enduring our stringent vetting process, analysts are accessible and available to discuss incoming ideas, but also push out to clients fresh information and ideas they are encountering as they assess the markets. Furthermore, this information is delivered exclusively through StreetBrains research HUB, to a finite number of customers.

To learn more about the benefits of the StreetBrains AIX, click here.

Alpha or Artifice?

A story titled “And God Created Alpha” from the January 5th edition of The Economist, knocks some fund managers off their high horses by making an important point about replicators and other tools/products being developed to mirror the returns of well-performing funds:

“…If those returns can be reproduced by a set of mechanical rules, is skill really involved?”

We’re not here to throw under the bus any fund managers who’s masterpiece-like returns have made them the idyllic poster-children for knock-offs and frauds, but investors should know that the faux-Picasso and the Canal Street Prada purse have found their way to the fund industry. The difference here is – if the returns are the same, will anyone care that it’s a fake? Probably not.

In a volatile market where hedge funds themselves are not able to generate the same volume of returns, can replicators really find their place in the market? Or will it be survival of the fittest, where only the top performing hedge funds will survive, the rest will fold, and replicators will vacuum up the dollars left behind by the vacating failed funds and go on to match the leaders?

Is there such a thing as ‘alpha’? If replicators succeed, will ‘alpha’ find itself thrown into a category with wives’ tales and urban legends? It could be a true concern down the road, but for now, replicators can’t win if they don’t have great fund performance to replicate. So, at very least, the top-performing funds won’t be closing their doors anytime soon.

However, with these new competitors trying to steal a piece of the pie, there won’t be any room for mediocre performance amongst hedge funds that have been riding the gravy train of ‘hedge fund’ allure. Where artifice substitutes for alpha, there will be abundant failure.

Securing Alpha

The surest way to ward off replicators is to outperform the indexes. Funds that find top-quality research and information to set them apart from the pack will be crucial if they are to outperform ‘synthetics’.

As The Economist story points out, “it’s certainly not a crisis yet…but it ought to be a long term worry.”

The Investor’s Dilemma: Drowning out the Research Noise

Calling all institutional investors - raise your hand if you agree with this statement:

“The volume of research I receive is impossible to review, and all it does is clutter my inbox.”

Yet another prospective client made this very statement today. It feels good to know we’re the solution, not the problem.

The tides have turned for investment research, and independent research providers, by and large, have not been quick to adapt to the new needs of their clients. Clayton Christensen (author of "The Innovator’s Dilemma"), who brought us the notion of ‘disruptive technology’ – would say that the investment research industry is missing a tremendous opportunity.

Consider this:

Not long ago, research reports used to stack up on our desks, and we’d have to sort through them page by page. Now, the new dilemma in research is that instead of research overrunning our desk space, it’s cluttering our inboxes.

Where does it end?

Some companies, such as themarkets.com think they’ve done clients a grand favor – they aggregate all of the research the client has purchased, and they allow them to filter it and make it searchable, so the volume of research is more manageable.

Perhaps I’m missing something, but wouldn’t it make more sense to just pay for the research you want – as opposed to paying for research you may or may not want and contracting another party to filter what you’ve paid for?

And then, taking it one step further, simply make that research available in one place, rather than having 75 emails in your inbox every morning that you’ll never be able to sort through?

Not to preach, but we think StreetBrains’ research solution would make Mr. Christensen proud.

Today’s Lesson: Unclutter clients’ inboxes. Provide to them what they pay for, in a format they prefer.

[Off soapbox.]