For BNY Jaywalk, a subsidiary of the Bank of New York, the recent move from its midtown Manhattan location to the bank's storied offices at One Wall Street was more than a validation of the division's enhanced importance at the bank. Jaywalk's newfound prestige speaks to the growing importance of an entire industry.

Two years ago, Jaywalk sold the research of 15 independent research shops. Today, the industry has grown so large that the research of about 180 indies flows through its doors.

Jaywalk President John Meserve admits that the rapid growth of BNY Jaywalk and the rest of the industry has been spirited along by the global research settlement of 2003, which originally mandated that 10 Wall Street firms offer independent research to their brokerage clients. But it's the possibility of soft-dollar disclosure that could prompt mutual and pension fund managers to finally discover that independent research is a better value than that sold by Wall Street firms.

At present, soft dollars account for as much as 60% of the independent research industry's revenues. Until the Securities and Exchange Commission decides how to force brokerage firms to make research a transparent or separate part of trading fees, the growth the independent research industry has achieved over the past two years may well slow down.

But should that happen, the world of research could change. "If research can be broken out, and there's a level playing field as to what one gets with the dollars spent on research, then independent players will be big winners," Meserve said.

Mutual funds continue to pay for research using soft dollars - commissions that are used to pay for a number of services, primarily trade executions. However, indie research, while also paid for in soft dollars, is priced as a stand-alone product that mutual funds typically pay for out of their management fees, rather than through trades. Recently, low returns have led several mutual funds to cut back on their independent research.

Brokerage firms themselves often pay for third-party research with hard dollars, thus making it possible for money managers to ask them what they spend on this third-party research. While it's theoretically possible for a brokerage to estimate what it costs to produce internal research, Wall Street argues that's quite complex and time consuming. But the indie industry is pushing brokerage firms to determine this cost to level the playing field. And if that happens, not only are fund companies likely to see trading costs come down, but they could have access to more higher-quality independent research.

"These are the most financially and technologically sophisticated companies on the planet that, for a living, negotiate a bid and an ask to come up with a price thousands of times a day. The idea that they can't price their research is preposterous," said Scott Cleland, director of the independent research industry's trade group, Investorside Research Association. "True competition between independent and proprietary research could work wonders, but the competitive playing field is tilted very heavily against independent research."

Mutual fund investors are getting wise to that, as well. A recent Thomson Financial poll of institutional investors indicates that nearly half said there is poor disclosure on bundled commissions, and nearly 81% said bundled commissions are not the right mechanism to use in funding research.

Another ray of hope comes from the U.K.'s top financial regulator, the Financial Services Authority (FSA), which has also been exploring the soft-dollar issue and has suggested, in spite of fierce resistance from brokers, that it would make sense for them to charge separately for trading and research. If the FSA bans soft dollars or spells out how research and trading should be separately paid for, U.S. firms operating in the U.K. will have to abide by that, and brokerage firms worldwide will have difficulty arguing that unbundling is prohibitively difficult to enact.

Smart' Mutual Funds

"Probably the best thing for the industry over the long haul would be an equal playing field" on the cost of proprietary and independent research," said Michael Mayhew, chief executive officer of Integrity Research Associates, an equity research consulting firm. "The market should go to a place where the quality of ideas determines what you get paid. Not where you can bundle it into the price and nobody can tell the difference.

"Some of the bigger mutual fund complexes are beginning to ask their Wall Street brokers to break down their research and execution costs," Mayhew said. "Smart mutual funds get it."

Unbundling, whether by regulatory fiat or, more likely, by the will of slow-moving institutional investors, would arguably herald a golden age for independent research. But in the meanwhile, the current environment for indie research might best be termed a hopeful malaise.

"We may, in fact, be hitting a period of retraction, primarily a result of the deterioration in commissions and uncertainty in soft dollars," Mayhew said.

Soft-dollar payments have been under scrutiny for more than a year now, with an SEC task force investigating the issue. Some fund companies believe the SEC could decide to eliminate the soft-dollar exemption for third-party research entirely, and as a preemptive strike, several large fund companies, including MFS Investment Management and Janus, have discontinued their use of third-party soft dollar relationships with independent firms.

Jonathan Meeks, a principal at TA Associates, a private equity firm that has invested $60 million in the Center for Financial Research & Analysis (CFRA), a leading indie research firm, said the confusion over soft dollars has misled some money managers into thinking that research and trading need to be tied together. "Anything that offers transparency and favors the unbundling of those two very different services to the institutional investor community will be a positive event for the industry," he argued.

In fact, hedge funds have become a major buyer of indie research recently. Should hedge funds become armed with even more proprietary research, that could put mutual funds at an even greater competitive disadvantage. Certainly, hedge funds don't seem to have as much concern as mutual funds for the politics of the soft-dollar debate.

It's possible regulators will force the issue of transparency of research pricing. However, this outcome seems unlikely due to pressure from mutual funds that favor paying bundled commissions and from bulge-bracket brokerage firms content with the status quo.

Or perhaps, as seems increasingly likely, pension fund institutional investors will fight against paying an opaque commission simply because it would be difficult for Wall Street to disclose the true cost of brokerage firm research. If these decision makers recognize this and act to remedy the situation, independent research could achieve pricing parity with Wall Street, and all investors, mutual funds and their shareholders included, will reap the benefits.

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