Traditionally, bulge-bracket firms have given away research in exchange for trading volume and high trading commissions. The commissions paid for part of the research, while investment-banking fees paid for the rest. Over time, Wall Street firms built up expensive operations, flush with highly paid salespeople and large travel and entertainment budgets.
But now, with the banking fees gone and trading commissions under tremendous price pressure from electronic exchanges and the pursuit of best execution, research budgets have cratered. Staffs have been cut, making formerly common research now less common and starving for resources. We hear portfolio managers saying that they are trying to direct the lowest amount of commissions to bulge-bracket firms, and make better use of their trading dollars for independent research.
Soft dollars offer a way to pay for research outside of the traditional firms. In addition to helping pay for some data feeds, soft dollars allow fund managers to search out sources that weren't based in New York and knock on the door of institutional investors for research sources that were totally independent of trading.
Several years ago, our research firm, Stax, was approached by Highline Capital, a long/short hedge fund, asking us for a due diligence piece of work. They preferred, they said, to have independent and exclusive research, different from the major providers sending them research on a day-to-day basis. They could apply the commissions, otherwise going to a bulge-bracket firm, to pay for this research. For an investor, this makes uncommonly good sense, to send commission dollars to the place from which you get the most total value. Then we got a call from Highline's soft-dollar firm, Hoenig, seeking confirmation of the type of research Stax was undertaking on behalf of Highline. They also asked to meet with us in order to fulfill compliance requirements.
What if Highline hadn't had the soft-dollar option? They could keep sending trading dollars to the firms that were not providing research value. Or, they could pay cash and charge it back to their investor pool, which many of our fund clients still do. But if they pay cash, it becomes more work for them to set up accounts for every independent vendor, and they have no outside compliance. Although efficient back-room operations are critical to a fund manager, the last time I checked, no one ever backed a portfolio manager because he was great at vendor management.
Different Skills
Alternatively, as many have suggested, and several research firms have done, we could have opened up a trading desk of our own. Think of the librarians, private investigators, Ph.D.s in statistics and highly analytic types that you know: These are people who do thorough investigating, thinking and cross-checking before coming to a conclusion. Do any of them strike you as likely good traders? Why would you ask the management of a highly skilled research firm to go through the effort and expense of opening a trading desk, if it were counter to their skills?
Let's consider a research firm opening a trading desk from the client side. As an operator of a fund, you want your analysts and portfolio managers to have access to the best research ingredients to conduct their analyses and make their investment decisions. You want your trader to focus on providing market insights to your portfolio managers and on delivering best execution. Let's say your portfolio manager has a $200 million position in the homebuilder sector and wants to buy an exclusive study on the industry, something he might do twice this year. Who in your operation wants to add a new trading relationship just to pay for that one-time study? Let's suppose the buy-side team wanted to buy research from a particular firm every other week. It's possible the trader may not want to place the orders with that firm because it doesn't offer best execution.
Asking if there have been soft-dollar abuses is just like asking if there has been expense account abuse in corporate America. Does it happen? Sure. Do most firms have controls in place to make sure that such abuses are avoided at best, or minimized at worst? The firms that we work with do. They want invoices with explanations, without breaking client confidentiality, as to the results of our research. They want to meet us and understand what we're doing, and they want to make sure we're in compliance. And some of our clients have purposely asked for soft-dollar auditing, to make sure that their investors would approve.
With the changes in revenue and cost structure on Wall Street, the independent research business has sprouted many a new firm in an already fragmented market. Depending on how you classify them, you could probably count all of the independent firms above $20 million on two hands. A typical soft-dollar firm paying out $100 million in fees to boutique research firms has little supplier concentration, with maybe 10 research firms being paid more than $1 million of those fees. I believe that Merrill Lynch's soft-dollar arm pays more than 900 providers to clients.
A fragmented research world is good for investors. If there were 10 behemoth research providers, then they would likely sell to all of the same top mutual funds, and nothing would be different. As an investor, I would want a fund manager who excels in finding and analyzing the right information to reach what should therefore be, a superior investment decision on when to buy and when to sell. If an investor knew that his money manager was only using the same information as every other money manager, he would start to think of his manager as a closet indexer.
The soft-dollar firms provide a secure payment infrastructure to help institutional investors and independent research firms work together. Soft dollars help research firms focus on what they do best, and help institutional investors move trading volume to extract maximum total value to their investor, in this way, gaining the best research and execution. In fact, many of our clients go to their best-execution provider, and ask them to set up the soft-dollar account and compliance.
So what happens if you were to stop soft dollars, even for a short time? You'd stop the payment mechanism for a host of independent firms. You'd turn off fuel and food for the industry. Some of those firms would just go away, while others would have less to invest in their products. Ultimately, the end investor would suffer.
Some larger funds, I'm hypothesizing, would rather see soft dollars go away for competitive reasons, as this is a good way to restrict smaller funds from accessing better research. The likely thinking at large fund companies with armies of analysts is that restricting access to independent research at smaller funds will help them. It might for the short term, but the good investment firms will work on a cash payment system, and build another compliance mechanism.
Ultimately, they will catch up, but it will take some time, and cost everyone by hobbling independent research in the meantime. I don't know about the concentration of America's wealth in a few behemoth mutual funds, but I seriously doubt the SEC or the U.S. Senate is looking to publicly protect the big funds and help them monopolize market information.
I'm regularly surprised when I hear a fund analyst say they don't know how their firm pays for independent research, so they cannot compare the cost of buying research out of what we already get. As the head of my organization, I always have to ask my team, "What can we do to make sure we have easy access to the best resources, so we do the best job for our clients?" Ask yourself the same question, then ask again why you would end soft dollars.
Rafi Musher is chief executive officer of Stax, an independent research and consulting firm with offices in Cambridge, Mass., and Chicago.
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