For Getting Value from the Sell-Side, TOPS is Tops

As I was catching up on some back stories in my RSS reader, I came upon a piece in Wall Street & Technology concerning a trend towards the buy-side's more vigilant tracking of the sell-side's trade ideas. The story is ostensibly about vendors providing tools and technologies for capturing and analyzing sell-side idea-driven performance data. Interesting, I thought. But then I said to myself, "Wait a minute. You know a firm that has been doing this - and doing this incredibly well - for five years."

The firm: Marshall Wace. The strategy: TOPS (short for Trade Optimized Portfolio System). And, believe me, Marshall Wace isn't selling this technology to anybody. But they did sell shares in a vehicle leveraging the TOPS algorithms - MW TOPS Limited - to investors back in late 2006. And based on the historical performance of TOPS, the offering was a blow-out. The reason: because when sell-side research is benchmarked on a performance-basis, some of it can create real value. The problem: the signal-to-noise ratio is very, very high. And Marshall Wace figured out a way to extract the "needles in the haystack" for the benefit of themselves and their investors. Pretty cool stuff.

A little background on the MW TOPS offering, from the Marshall Wace press release dated 11/13/2007:

Investment highlights

- The offer provides direct access to the investment expertise of Marshall Wace, one of Europe's leading equity long/short managers.

- The new publicly-listed company will invest in Marshall Wace's successful TOPS strategies.

- TOPS is a process which collects and evaluates investment ideas generated across the securities industry, so as to create optimised portfolios which have historically delivered attractive risk-adjusted returns.

- The Company will initially invest in two existing TOPS strategies[1]: Opportunistic TOPS[2] (inception 1 July 2002) and Fundamental TOPS[3] (inception 1 October 2003), which, since inception to 31 October 2006 generated returns (on a gross of fees basis[4]) of 146.81% and 76.48% respectively (equivalent to 23.18% and 20.23% respectively[5] on an annualised basis (to 31 October 2006)).

- The Company will target annual returns (net of fees and expenses) of 12% to 16% with a volatility of 5% to 7%[6].

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- Investors in the Company will participate on an equal footing with other investors in the existing European TOPS funds. These other funds will be closed to new investors from 1 December 2006.

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And a little additional commentary from FT Alphaville concerning the offering and the FSA investigation into preferential treatment of certain investors:

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Marshall Wace, well established now as one of Britain’s leading long/short hedge funds, uses a “best ideas” box that crunches every available piece of investment banking research to come up with optimum investment recommendations. If the hedge fund follows particular ’sell side’ advice, the investment bank concerned picks up commission according to a ranking system.

It’s an approach that has produced some consistently good returns — typically more than 20 per cent, before management fees, over the past five years.

It has also produced some mutterings — specifically that the approach encourages sell side analysts to offer Marshall Wace their best ideas on a preferential basis, so as to secure commission. However, in late September, the Financial Services Authority cleared Marshall Wace and other operators of so-called Alpha capture systems of any wrongdoing, saying the firms had a series of checks in place to prevent market abuse.

Indeed, an FSA study found that because of the clear audit trails produced by these systems, the “risk of (explicit abuse) might be lower than through traditional communication methods.” What the watchdog meant is that it’s easier to break the law by passing on a tip in a bar, say, than processing research in a computer.

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So, my key take-aways and conclusions:

• Marshall Wace is the shining star of sell-side performance tracking and Alpha capture systems, and has been refining their model over the past five years.

• The TOPS approach, when subjected to regulatory scrutiny, was cleared as a vehicle for trading given the controls Marshall Wace had in place and the audit trail naturally created by Alpha capture systems.

• A wave of new vendors are coming online to help buy-side shops track the performance of sell-side trade ideas. These are simply measurement and tracking tools, not models for alpha generation.

• The Marshall Wace experience indicates that the sell-side has the potential to offer alpha-generating ideas, but that screening, performance measurement, trade sizing and risk management are critical to making the success of a sell-side "best ideas" approach a reality.

• The sell-side will come under increasing pressure as the field of idea performance measurement evolves. This will lead to dramatic shake-out in institutional sales platforms across the broker/dealer community as only the best (read: generate good ideas that generate commissions) will survive.

• Enduring quality of sell-side trade ideas is a question mark because those who consistently generate the best ideas for their clients will eventually be lured away by their clients, start their own shops or move to in-house prop trading desks. Why make salary + bonus when you can get a percentage for your trade ideas? This is a natural evolution that will invariably (and already has) take(n) place.

Without question, increased utilization of tools and applications for performance measurement and tracking around sell-side trade ideas is an inexorable trend. This is a good and healthy process for the buy-side and the sell-side alike. The only problem is that it will be very painful for the sell-side as a shake-out ensues across institutional sales platforms, and for the buy-side as the best idea generators move to higher-paying, purely performance-driven opportunities. The net result: the best idea-generating talent will migrate towards broker/deal prop activities and hedge funds, furthering the sell-side "brain drain" and hastening the shift towards an increasingly trading-driven world.