19 November 2012

CSFI Report: "Independent Research - Because they're worth it?"

Excerpted from Conclusions

The picture that emerges from the CSFI/Euro IRP Survey 2012 backs up the conclusion from last year’s report, “Has independent research come of age?”, that the independent sector has become an established part of the research market that is highly valued by its buy-side customers. Almost half of those surveyed are paying for independent research – and a significant minority is paying substantial sums. The quality of independent research is considered to be improving and the majority of those paying for it expect to maintain or increase their consumption over the next few years. As a whole, the sector is expected to maintain or increase its market share relative to the sell-side competition.

Based on this positive picture, it would be tempting to recommend that IRPs adopt a “carry on as you are” strategy. However, independent research does not operate in a vacuum and it would be foolish to ignore the wider financial market backdrop and emerging trends within it.

The financial services industry has realised that, after the global crisis, it is not operating in a normal cycle. While there are some cyclical factors affecting investment banking revenues – the current low level of initial public offerings, for example – the bigger picture is one of structural change. The areas that banks operate in are more restricted and their activities will become more expensive in terms of the regulatory capital needed to support them. Tougher regulation is here to stay – a realisation that grows stronger with each successive banking scandal. The bottom line is that many banks still have an operating model geared to historic volumes of activity and are continuing to downsize their businesses.

However, sell-side contraction does not imply an easier ride for the independent research sector. As well as attempting to cut their costs to levels more suitable to their revenues, the banks will fight to gain a larger share of the businesses left open to them. That competition is likely to be even fiercer because the available pool of fund management commission income has declined markedly from its pre-crisis peak and is continuing to shrink. The buy-side is trying to allocate a smaller amount of money among banks, which are even hungrier for revenue than before.

The last piece of the background jigsaw is that not only are the participants facing a more difficult market, but the nature of the market is changing too. High-frequency algorithmic trading and low-cost ETF passive investment strategies, which have grown rapidly in recent years, have no need for research. In a market where passive investment is cheap, there is an increased need to generate alpha to justify the cost of active management.

Just as the application of technology has transformed equity trading, it is now being brought to bear in counterparty relationship management between the fund management industry and those who provide research and trade execution services.

The need for both sell-side and buy-side to allocate resources in the most efficient manner, while dealing with a proliferation of information, is prompting wider adoption of tailored software to manage broker relationships. The need for greater transparency around price-sensitive information and broader regulatory trends provide impetus for the adoption of a more formalised approach. While much of the industry still operates informal broker voting processes, the direction of travel towards more rigour is becoming clear.

The question asked in the title of this report was “Because they’re worth it?” The answer from the survey results and the interviews with research users is that IRPs are indeed perceived to add value. But if the challenge is to prove the creation of value – whatever the client’s investment horizon – the sector needs to embrace the new reality in financial markets and adapt accordingly.

Full report

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