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

The ‘Race to Zero’ Zooms On

The fact that commissions are drying up, and that brokers are competing over a half or a quarter of a penny at this point to win execution dollars, is nothing new. However, the Race to Zero will kick into high gear in 2008, as research desks get slashed at large firms (which used to be an ‘add on’ that justified higher execution pricing), and the surge in unbundling execution from research sends clients searching for best execution providers.

Brief History

With the onset of the tech era, commissions started facing their first hurdles in the 90’s. New execution providers flooded the market promoting faster and cheaper execution than ever before. Existing brokerage firms were able to implement similar technologies that also touted volume scalability that kept them in the game. As technology improves commissions become increasingly more commoditized, and thus coined was the ‘Race to Zero.

Current State of the Union

Large brokerage firms now look primarily to volume, not pricing as the key to feeding the execution beast. However, as most large brokerages look to slash their workforce, the research departments – long considered a ‘cost center’ and often referred to as the ‘red-headed stepchild' of the brokerage world – will certainly take a hit. With less research being written internally to justify higher execution pricing, unbundling research will almost evolve organically from the current issues in the market.

Mid and small executing brokers who provide research – despite their hopeful musings that the sky is not in fact falling - are facing some trouble. Many seem to have hung their hat on the idea that hedge funds want to continue to use an over-abundance of executing brokers, so that competitors won’t be able to follow their trading patterns. Based on our talks with market insiders, this notion seems rather unreasonable. We’re not suggesting that any hedge fund out there is handing his entire trade book over to one execution firm, but minimizing the number of executing brokers is not only something most have said they’re willing to do – from a cost point of view, it’s a priority.

Mid and small guys who recognize the threat on the horizon still have the opportunity to choose a business, any business – either research OR execution – not both – and have a chance at survival.

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.

Rejecting Researchecution

Just as Hollywood’s got Brangelina and TomKat, Wall Street has Researchecution: a hybrid coupling that seemed like a good idea once upon a time, but ultimately has the shelf-life of canned fruit.


The days of Researchecution – the ‘bundling’ of research and execution costs - are very close to numbered here in the US, and are already a thing of the past in the UK. Increasingly more Wall Street firms are asking themselves why they continue to bundle these services, and the case for client commission arrangements (CCAs; commission sharing agreements/CSAs; soft dollar arrangements, etc, etc.) to aid ease of payment for a la carte research - while enabling best execution pricing - is gaining traction. However, this isn’t the first divorce that some on Wall Street have been reluctant to embrace.

Not long ago, you may recall the painful breakup of investment bankers from their beloved research desk counterparts. Although research had been a supportive and loyal partner, investment bankers abused the relationship, and eventually divorce ensued.

The same separation is imminent for research and execution. The issue of transparency over what monies pay for execution vs. what monies pay for research will eventually come center stage – whether it be on a regulatory level, or internally at firms as they struggle to justify all spending in the current volatile market.

The questions that firms are starting to ask themselves are: “What are the benefits to unbundling research from execution? Will it save my firm money? Is it necessary? If so, why has the SEC not implemented a rule requiring unbundling? What advantage will it provide? Will it cost me more in compliance?"

Integrity Research’s blog on Sunday offers a ‘state of the union’ for the current environment for CCAs. At StreetBrains, we’ve been having these same discussions with clients and potential clients as well. The landscape for CCAs is still somewhat uncharted territory and some firms are hesitant to jump on the CCA bandwagon. However, an increasing amount seem to see the value and advantages to unbundling.

To answer the questions above:

1) The benefits of unbundling research from execution are many. First, you will be able to ensure you are getting best execution pricing (since you won’t be ‘factoring in’ research costs.) Second, you can pay solely for research you want and use, rather than being bombarded with research you neither want nor need. You can establish relationships solely with those research providers you value and trust. Third, unbundling research costs from execution costs make for more transparent bookkeeping – and although there is no rule that currently requires that level of transparency, the likelihood of such a rule coming about is imminent.
2) There is little research out there thus far showing whether or not unbundling saves money. What we do know is that unbundling helps firms to more accurately assess the value of their research purchases, so they are able to adjust spending accordingly. Although the cost savings are still unclear, what is clear is that unbundling provides a clearer picture to assess what you are paying for. In a market environment where purse strings are tightening, the ability to pinpoint the cost: value ratio is of utmost importance.
3) Although there is no rule currently requiring research to be unbundled from execution pricing, such a rule is likely to come – and soon. So, using CCAs would seem (and does seem, to many of our clients) to be a no-brainer – stay ahead of the regulatory curve; get a clearer picture of what your firm is spending its money on; and pay for what you value. (best execution, and great research.) Additionally, unbundling improves transparency without adding to compliance costs.

Many more firms are beginning to understand the implicit value of unbundling, and are looking to independent research providers such as StreetBrains as they divorce Researchecution. To learn more, please visit our complete “Myths and Facts” page that helps dispel some common myths about paying for independent investment research.

Dispelling Common Myths About Independent Research

We spend a lot of time talking to our clients and to potential customers, and most days, the issues they discuss with us are the same. So today's blog will address the 7 most common misconceptions we hear - and offer our responses to the issues.

7 MOST COMMON RESEARCH MYTHS

MYTH #1: “All investment research is the same.”

FACT: StreetBrains takes research a step further than what currently lands in your inbox – our research focuses on specialized sectors, niche trends, and unique companies that will help you to garner unmatched returns.

MYTH #2: “There’s no such thing as truly independent investment research.”

FACT: StreetBrains has no investment banking arm or broker-dealer, so our analysts are able to offer opinions free of any conflicts of interest. Period.

MYTH #3: “My firm doesn’t pay for independent research – We get it for free.”

FACT: If your firm pays for execution and is provided with research as an ‘add-on’ or ‘bundled’ service – your firm is paying for that research. “Bundling” of research and execution makes for opaque record keeping, and will soon become extinct.

MYTH #4: “Unbundling research from execution services probably wouldn’t save my firm any money.”

FACT: By unbundling research from execution, you can secure best execution pricing. Then, you are able to take your research dollars and pay separately - and more transparently - for high quality research that delivers actionable information and profitable returns. Unbundling is gaining steam as the preferred approach to obtaining quality research.

MYTH #5: "When the global research settlement terms end in 2008, firms will do away with independent research."

FACT: Although the ten firms involved in the global settlement will not be required to distribute independent research, these firms, as well as most other large firms, have publicly noted their intentions to continue offering third-party research. Because the global settlement required firms to handle their in-house research differently, independent research continues to be a valuable asset to the firms.

MYTH #6: "Soft dollar payments for research will soon be eliminated."

FACT: Although the issue of soft dollar payments looks likely to move to the SEC's front burner before the end of 2007, it is unlikely that soft dollars will be eliminated. It is unlikely that more disclosure and regulation will be required under current soft dollar arrangements, however, the SEC will be looking for ways to show mutual fund boards how they can easily distinguish proper soft dollar arrangements from bad. License-fee payment models - such as StreetBrains' - help deliver transparency of pricing in soft dollars arrangements.

MYTH #7: "Fundamental research is still the most widely used and desired investment analysis."

FACT: According to a recent study by Integrity Research Associates, specialized research has outgrown fundamental research as the leading category of analysis for independent research providers in the UK. As fundamental research becomes increasingly more commoditized, institutional investors continue to search for analysis that gives them an edge on their competitors.