Viva La Third-Party Research
According to BNY Research president John Meserve, the heart of the soft dollar debate is not about third-party research. "Itís about the Wall Street firms" and whether they should have to unbundle their proprietary research, he said. The Street has opposed unbundling because it "attacks the heart" of their business model.
If the big issue is unbundling, rather than third-party research, why have so many fund groups announced that they will no longer soft third-party research?
SEC associate director Robert Plaze said that heís been told that the decision was made not because the adviser thinks softing third-party research is "wrong," but rather that the adviser is "tired" of having to explain why it is softing third-party research to clients. "Itís easier for them" not to soft it, he said, speaking at the recent Mutual Fund Directors Forum.
Clearly, the SEC is not planning to distinguish between proprietary and third-party research. Noting that the Investment Company Institute has called for an approach that would treat third-party soft dollar research different from proprietary research, Plaze remarked: "I donít think that itís likely that thatís an approach the Commission will take."
SEC Chairman William Donaldson, quoted February 22 in the Financial Times, put it more plainly: "Anything that inhibited third-party research being done outside the big firms would be a real mistake."
That, according to Meserve, is a good thing. In his view, third-party research is more robust than Street research. "Wall Street firms are going to ĎResearch Liteí," said Meserve, speaking at the Forum. "Theyíre pulling back their research. Less and less companies are being covered" and research analyst compensation "has dropped dramatically."
Meserve noted that when regulators visit a firm "they spend three hours" going over the ten to fifteen percent of the research that comes from third parties, and only "three minutes" on the proprietary research.
Why? "Thereís no way to measure it," because proprietary research is not unbundled. "Itís not auditable," he said. "Firms get frightened by that." In contrast, third-party research services are priced explicitly. "Third-party research is easy to go after because it has price tag," said Meserve. "Thatís why the Wall Street firms are fighting tooth and nail to not disclose to you what their executions are." But he noted that some firms already are demanding that their brokers unbundle. "Theyíre calling their brokers, having them sit down with them, and saying ĎGive us a P/L, [tell us] what services we get from you.í"
Meserve raised the following question: For any firm that ceased paying for third-party services, "if one cent goes away, then theyíve breached their fiduciary duty, right?" In other words, once an adviser announces that it has started paying cash for third-party research that was previously paid for by commissions, "if their expenses for third-party research go down, they have not done what they said they would." He urged fund boards to question advisers taking this approach: "Did you cut back on anything? On any service?" The level of expenditures, he said, "should not change."
In any event, Meserve said that advisers should be concerned about providing "best of breed" (i.e., third party) research to their portfolio managers. Currently, he said, the best research is going to hedge fund managers, "because the process for paying for research is not opaque," he said. "Itís very clear. If you add value you get paid. Itís not a long convoluted discussion."
One of the "biggest trends" in the third-party research space is providing portfolio managers with direct access to industry professionals, he said. "Itís like Match.com for industry experts." For example, letís say a portfolio manager wants to talk to three cardiologists in the Southeast to discuss a recall of a particular medical device. They want to find out "whatís happening in the field." A third-party provider, he said, can provide these "grassroots" contacts in various industries, such as shipping, energy, health care, and telecom.
Meserve argued that third-party research should continue to be paid for out of commissions, rather than hard dollars. He gave the example of a portfolio manager asking the firmsí CFO for $100,000 to purchase a research report from a forensic accountant. Presented with such a request, the CFO is naturally going to ask questions, such as: "Who is he? Why do we need it?" The portfolio manager might respond: "I donít know if we need it." However, asked Meserve, if that $100,000 independent research keeps the firm from moving a million shares of a Parmalat or an Enron, is it worth it? "I think it is." And, he noted, commissions pay for more than just research. "Itís access to management, itís IPOs, itís capital, and . . . itís execution ó all in that opaque bundle."
He also expressed concern about the SECís narrowing the definition of research, noting that some third-party research, such as the "Match.com" services, may not look like traditional research. "You donít want to be in the business of trying to see ĎIs that research or not?í" Portfolio managers, he said, need to put together a "mosaic" of information. "They need all those data points," such as information about shipping trends or natural gas loads. "Thereís a lot of interesting research that you donít want to close out," Meserve warned.