Some Updated Thoughts on Sell-Side Research

Based upon the current sell-side research model, prospects for these legacy research providers (and the commissions that have largely supported these efforts) are increasingly poor. Hedge funds - accounting for approximately 70% of equity-based commissions - demand value for their research spend, and are finding less and less of this value emanating from the bulge bracket sell-side firms. So how are these fund spending their research budgets?:

• Building in-house research capabilities. While not every firm has the budget and the scale to undertake such an effort, those that can are doing so and keeping idea generation inside the firm. By doing this, these firms are fully bifurcating the research decision from the execution decision, maximizing quality control while minimizing costs.

• Leveraging alternative research tools. A new type of tool vendor has emerged over the past few years, one that is designed to aggregate, parse and analyze information from a wide range of disparate sources, with an eye towards mitigating the signal/noise problem that plagues the research analyst, portfolio manager and trader. Monitor110 is one of these new-age financial intelligence vendors. This helps institutional investors cast a wide information net without having the devoting the internal resources necessary to staff such an effort.

• Engaging expert networks. Rather than relying on sell-side research analysts to do general legwork, which is then broadly disseminated across hundreds or thousands of clients, an increasing number of institutional investors are using targeted expert networks to mine for the data they really need. And their findings aren't published and widely distributed. This, like the alternative research tools, is a vehicle for maximizing return on human capital and making the analyst's job more efficient.

• Buying selective independent research. There are certain boutique research shops that are very good at what they do, so good that an array of investors are willing to pay for their work. However, like classic sell-side research, this suffers from the "diminishing value of information" conundrum: as the company becomes more successful, the value of its research declines as its insights are more widely known, causing the information's value to decay rapidly.

• Buying selective sell-side research. Make no mistake; there is some good stuff being put out by the bulge bracket firms. Problem is, it is few and far between and not sufficiently pervasive such that it should be purchased on anything but an a la carte basis by the buy-side firms.

So in light of these mega-changes, what is a Wall Street firm to do?

1. Sharply scale back the sell-side research operation, only focusing on those areas where the product delivers true value-added. The research should be of such quality that a hedge fund would be willing to pay hard dollars for it. This will take huge costs out of a firm's equity and banking divisions. This is the good news. The bad news is that it doesn't solve the declining commissions problem.
2. Cannibalize the existing research operation by doing deals with alternative information providers, independent research shops and expert networks. This is sort of what Goldman's Hudson Street appears to be doing. By offering institutions these leading-edge tools as part of its service offerings, it is delivering real value to clients that they are willing to pay for. Might this hurt the commissions flowing from sell-side research as clients do more of their own homework? Yes. But might this protect the overall commission pie that the sell-side is currently capturing? Yes. And if the big sell-side firms don't do this themselves, the market will invariably do it for them.
3. Bring the sell-side research business into the 21st century. Sell-side research analysts should be using the same kinds of tools and technologies as their sophisticated hedge fund clients. Problem is, many analysts are caught in the last century's mind-set and ways of doing business. It just makes no sense. If they want to be valued, then they need to go where all sources of value are found. And in today's world, a large source of that value is either on the Internet or can be discovered using the Internet. Until the sell-side research complexes realize this and get with it, they will encounter a slow, grinding decline with absolutely no hope of recovery.

As I've written about previously, I see huge opportunities in the realm of next-generation expert networks and strategies for monetizing alternative data.  All of this disruption can bring new life - a smaller, smarter, more nimble life - to the sells-side research business, if only they can embrace the creative destruction that is already afoot. Deny it if you will, Wall Street, but it will be at your peril.