Independent equity research gains users, but commissions remain static

Among more than 1,000 buy-side equity analysts interviewed by Greenwich Associates as part of its 2007 US Equity Analysts Research Study, almost 40 per cent say they expect to increase their use of products and services from independent or ’boutique’ research providers in the next 12 months.

However, commission payments to independent research providers do not appear to be increasing in absolute dollar terms. ‘When looked at in light of the increasing usage reported by buy-side analysts, we have to wonder if some non-broker/dealer independent research providers are having trouble getting paid for their products,’ says Greenwich Associates consultant Jay Bennett.

The expected pick-up in the use of independent research by analysts is consistent across the various types of institutions that constitute the US equity buy side. Mutual funds are predicting the biggest move into independent research, with 56 per cent of mutual fund analysts reporting that they expect to increase their use of research from providers other than full-service brokers.

Nearly a third of analysts employed by long-only investment managers say they expect to increase their use of independent/boutique research, and another 6 per cent predict a significant increase. Across all types of institutions, the majority of respondents – 57 per cent – say they expect no change in their use of independent research.

Meanwhile almost 20 per cent of the analysts interviewed say they expect their institutions to reduce or significantly reduce their use of full-service broker research in the coming year, while only 9 percent expect it to increase.

‘Nearly 30 per cent of the hedge fund analysts interviewed as part of our research say their funds will cut back on the amount of full-service broker research used in the next 12 months,’ says Greenwich consultant John Colon.

These results seem to paint a positive picture for the independent equity research industry. But Greenwich Associates research among buy-side portfolio managers reveals that institutions cut the amount of commission dollars spent on independent research to roughly USD750m in 2006 from USD775m in the prior year.

‘Our research illustrates that, compared with the USD5bn paid out by the buy-side for broker research, sales services and corporate access services, independent research is a small part that does not seem to be increasing in step with its perceived popularity,’ says consultant John Feng.

The equity research industry has been in a state of near constant change since at least 2003, when 10 of the largest US investment banks agreed to the USD1.4bn Wall Street research settlement with the Securities and Exchange Commission. With research isolated from investment banking, major securities firms have been forced to assess the value of their research franchises on a stand-alone basis as drivers of equity trading revenues.

For the most part, Greenwich says, the economics have not been favourable. Commission rates on US equity trades have been falling consistently and a growing share of institutional equity trading volume is being executed through low-cost electronic systems.

‘It is certainly fair to say that the Bulge Bracket banks have ‘re-sized’ or ‘right-sized’ the costs of their research departments in line with these new realities,’ Bennett says. ‘It was expected that many of these shifts would favour independent research providers, and to some extent they have.

‘But the restructuring of the Bulge Bracket research franchises is now largely complete, and the major broker dealers remain firmly committed to the equity research business as it now stands. From the perspective of independent and boutique research providers, the fact that their commission intake did not grow over the past 12 months during buoyant markets raises some troubling questions.’

It remains to be seen if the proliferation of client commission-sharing arrangements will help facilitate the flow of commission dollars to independent research providers. ‘Institutions have always had the option of using soft dollar arrangements to pay for third-party research,’ Colon says.

‘But it is possible that the recent SEC clarification of its position regarding the use of client commissions to buy research and the increase in flexibility and fluidity enabled by commission-sharing arrangements will increase the amount of commissions flowing to third party providers, especially non-broker/dealers.’