Now that the Securities and Exchange Commission guidelines on soft dollars are set, experts predict a resurgence in soft-dollar spending, and service companies see an opportunity to help firms navigate the safe harbor.
Cautious of compounding the credibility crisis that followed the investment banking research and mutual fund trading scandals of recent years, some fund companies had been playing it safe. While the demand for research continues to grow, questions swirled around who should provide it, and how those parties should be paid.
"Firms have been in a holding pattern," said Theodore Eichenlaub, a partner with Advisor Compliance Associates of Washington. Stories of fiduciaries gone wild, using commission fees for everything from pleasure junkets to their children's tuition, gave soft dollars a bad name, and limited some companies' willingness to use an important decision-making tool. "They have not been fully utilizing their soft-dollar capabilities," Eichenlaub said.
"There was a cloud over the industry, and a lot of managers that had issues with regulators stopped using commissions for third-party services," said John D. Meserve, president of BNY Research, Commission & Payment Services, a subsidiary of The Bank of New York.
Fidelity Investments was one of them. In an attempt to restore investor confidence, the Boston-based behemoth brokered agreements with Lehman Brothers to unbundle fees for trading from those for research, instead of paying for research with soft dollars. But smaller companies found that model unsustainable, putting them at a competitive disadvantage and forcing them to choose between the equally unappealing options of hiking fees or cutting back on research, especially independent third-party research. "That had a detrimental impact on the market," Meserve said.
The SEC guidelines, issued on July 18, took steps to correct that, ruling that spending commission revenues-or soft-dollars-on research, whether it is provided by sell-side firms or independent third parties, is fine, as long as it's for research only, not overhead or other costs. The SEC also articulated its support of commission sharing, common in the United Kingdom, by which funds can direct a portion of commissions to cover broker/dealer trading costs, and use the remainder to pay for research from a different source, as long as it's accounted for clearly.
That's good news for both money managers and the research industry, which in 2004 accounted for $9.31 billion in retail and institutional spending, and is expected to hit $11.9 billion by 2009, according to a report from Integrity Research Associates, a consulting and research review firm in Darien, Conn.
"Now it's all systems go for independent research," Meserve said. Michael W. Mayhew, founder and chief executive of Integrity Research Associates, predicts that, in fact, independent, third-party research will dwarf its competitors.
"As we move to an environment of more transparency in how commissions are being spent, looking at research on an ongoing basis will be a critical issue for asset managers," Mayhew said.
And that's good news for service companies that can help money managers track their research, prove its cost to regulators and demonstrate its value to investors.
"The whole equation has changed," said Robin Hodgkins, chief executive of Cogent Consulting of Summit, N.J. In partnership with New York-based Tamale Software, Hodgkin's company released a product called ResearchTrack, which helps institutional investors and hedge funds categorize, store, track, share and, perhaps most importantly, rank all of the research they receive.
Besides collecting all related communication, including e-mails, reports, telephone logs, computer slide graphics and meeting records, into a single spot, while weeding out those items that are of no use, the program also helps fund managers value the research services. Analysts vote on how useful each research product is. Votes are then tallied to help quantify the price per trade or proportion of overall commissions. These figures can be expressed in a variety of ways, such as per user or per region, and in terms of basis points or percentages.
The software then spits out statistics that the money manager can use as a tool when determining how to allocate their research spending.
Decision makers can then use those allocations as guideposts to measure the services over time, and adjust the amount of business a research provider gets accordingly.
"It provides far more transparency and an even playing field," Hodgkins said.
And that's just what independent research providers hope for: an opportunity to prove that even if they do not provide execution, settlement services or other back-office operations, the research they conduct offers managers the information they need to make the investment choices that ultimately add value to the fund.
"It's not just research and not just execution. [It's about] quality and [providing] a method to the madness about how much you pay for their research," said Meserve, who added that such so-called research management solution software will become as important to firms as execution analysis programs.
From a regulatory standpoint, programs like ResearchTrack provide a record of exactly how commissions are spent. Because each user ranks the utility of the research he or she uses and the results are averaged, it would be impossible for a manager to steer commissions to an unqualified golf buddy without raising suspicion.
"While the SEC hasn't come out and mandated the use of these kinds of software products, the SEC has forced firms to be more responsible in the use of commission dollars," Mayhew said. He foresees funds will soon be asked to also value the research provided by sell-side providers, essentially breaking down bundled fees for their investors.
The ResearchTrack software provides the proof of that not just to regulators, but also to money managers examining their own operations.
"A lot of our customers have come to a Eureka!' moment," Hodgkins said. The new guidance encourages firms to take advantage of commission sharing to get the best available trade execution and research, even if they come from different sources. The software program helps portfolio managers take a more honest look at unbundled fees, said Mark Rice, chief executive of Tamale. It also gives them an opportunity to distinguish themselves and explain their investment choices to their shareholders.
And from an investor's perspective, that may be the best scenario. "At the end of the day, you'll hopefully see it in returns," Hodgkins said.
(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.
http://www.mmexecutive.com http://www.sourcemedia.com
