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Whether it was due to the Global Research Analyst Settlement, an acute shortage of skilled analysts, exorbitant costs, or the smart options available in external markets, sell-side and independent research provider (IRP) firms were first off the block in chasing the value of outsourcing. If the proliferation of third-party research providers in countries like India is any indication, then financial research outsourcing is well and thriving. Outsourcing has not only solved many problems such as costs, scale and turnaround times but has also helped these firms to push the envelope further. Today, even mid-cap and small-cap stocks that enjoyed little and at times no attention are being covered. Increase in the coverage universe has helped the sell-side to not only identify hidden value in under-covered stocks for their clients, but also earn more trading commission.
Given the fact that outsourcing markets, such as India have matured considerably, sell-side firms and IRPs do not hesitate to ask for higher value-added work. Consequently, companies in India such as Aranca now handle valuation projects of both listed and privately-held companies, hold management discussions and participate in analyst briefings, write initiating coverage notes for institutional investors and, among other things, undertake extensive and complex financial modelling.
For buy-side firms, things are not as easy. Yet the value proposition of outsourcing for buy-side firms cannot be underestimated. Hedge funds, for instance, are reaping solid benefits by moving a part of their work to outsourced partners. They gain from customised research, can get more complex work done at much cheaper cost, have the flexibility to ramp up or down the scale, get faster turnaround times and so on. No wonder, then that industry experts and media reports believe that buy-side firms may well herald the next wave of financial research outsourcing.
The problem of plenty
Traditionally, buy-side firms sourced almost all their research from the sell-side firms in the pre-regulation Fair Disclosure (Reg FD) era. They also benefited from bundled research, paid through client commission dollars as opposed to paying for their own research out of their own fees. All that changed after New York Attorney General Elliot Spitzer mid-wifed a USD1.4bn Global Research Analyst Settlement penalising top sell-side firms for their behaviour in areas where they had conflicts of interest. Together, these two moves wiped out sell-side firms’ single most important advantage: their ability to get selective information from companies they covered. Reg FD forced companies to stick to uniform disclosure norms, thereby levelling the playing field for sell-side operators.
What this meant was that sell-side firms started pushing research to the buy-side in expectation of trades, while the latter began wondering if they should create large research desks in-house and get unbiased inputs. The sell-side also had several problems to worry about, such as their research quality and analytical depth given the fact that the source information was public domain. Lack of soft dollars meant rising costs that quickly led to shrinkage of coverage, even as they strived to balance out between over-covered and under-covered stocks.
The buy-side had a different kind of problem. They received a great deal of research from sell-side firms – though much of it tended to be template-driven and consensus focused, it was still a problem of plenty. Moreover, not all market players are sanguine about sell-side research. "If you are a direct institutional investor, you either have a methodology that allows you to do your own work, or you're in a heap of trouble. To rely on the sell side is just not a viable investment strategy," says Charles Frumberg, founder and managing partner of Emancipation Capital in an article in Wall Street & Technology . A little harsh perhaps, for an industry that thrived largely on sell-side research inputs, but a fact all the same. Sell-sides dished out reports that were high on conformity but low on deeper insights.
Being inundated with research was expected. But when a stream becomes a torrent, what with IRPs, issuer-paid research, brokerages and others knocking at their doors, it does become difficult for the buy-side analysts and fund managers to shift through the ideas and spot the winners. Their internal research teams become stretched. In a world that is chasing Alpha all the time, such research added little value. As someone said, “You don’t need a 27th opinion on a stock!”
Today, dealing with information overload without losing time continues be a major challenge for the buy-side firms. Yet, unless they put in a substantial amount of work in searching for nuggets, they are not going to outperform the benchmarks. This continuous quest for great ideas in a tight market, combined with expensive talent, has forced many to look at fewer investment ideas. A bit ironical, considering they have access to a huge database of information. But perhaps there is a way out.
Done with back-office; now to research
According to one estimate, the global hedge fund market has nearly USD1.3tr in assets and is expected to grow to USD2.38tr by 2009. In comparison, assets under management in the mutual fund space touched USD10.28tr in November 2006. Active hedge funds number around 8000. Both sectors rely on good quality research and the acumen of fund managers to generate value for their investors. On the face of it, buy-side has three options to fulfil their research requirements: 1) Strengthen existing research desks to improve coverage (an expensive idea); 2) Set up a research team in a low-cost destination (have to deal with recruitment and retention pressures); and 3) Outsource research or portions of it to third-party research providers (quality, capability and confidentiality may be an issue). Each of these options has its upsides and downsides.
Hedge funds, which have extensive experience of outsourcing, can probably look at the last option as a viable alternative. After all, if third-party financial research works for sell-side and IRPs, then there is a good chance that they can do a similar job. Typical hedge funds consist of small teams and have had to necessarily outsource daily and operational activities such as cash services, NAV calculations, shareholder interaction, secretarial services, record maintenance, reporting, document custody services, and settlement reconciliation. According to a TowerGroup Research Note, a massive ‘…90% of hedge fund managers are already outsourcing their back-office fund administration, accounting, and shareholder servicing to a fund administrator.’
Outsourcing research, then, may be the natural next thing to do. Many hedge funds believe that their primary job is to focus on creating value for their investors, and tasks that are amenable to outsourcing without infringing regulations can and should be outsourced. We find that some have already made serious efforts in to outsource research. At Aranca, for instance, we work with several hedge funds on assignments of varying complexity, including information sourcing, template population, modelling and developing investment ideas, to the holy-grail of the investment world: idea generation. Our support has helped our hedge funds clients to benefit from a skilled and knowledgeable analyst pool, rapid scale, technology platform, and an inherent market advantage due to faster turnaround of research requests.
Finding the right partner
While many hedge funds are aware of how to manage an outsourcing engagement, some have to go through a learning curve to get the best out of their outsourcing partner. Following are some tips to help hedge funds to choose the right partners and plan their outsourcing strategy:
Planning for and managing high-end outsourcing is easier said than done. The outsourced partner must be capable of delivering similar or better quality output at competitive cost. In that sense, a successful outsourcing relationship is as much a function of the sourcing company's management skills as it is of the outsourced firm's delivery capabilities. If we were to consider a typical financial research project involving fundamental analysis of a stock for institutional investors, then what really matters is not a few dollars saved by chasing cost. Rather, it is the capability, rigour, resources, and rapid turnaround times, and the ability of the outsourced partner to adapt to the client's requirements and processes and deliver to specification.
In many cases, outsourcing institutions typically have `their way' of working and looking at the market. For the outsourced partner, it then becomes imperative to be agile, resourceful and skillful in learning the client's `way' without impinging too much on the latter's time. Keeping the learning curves short, ramping up quickly and delivering quantity without diluting quality are the most important attributes for the outsourced partner. In a way it is tricky, but successful outsourcing companies know how to make maximum use of the client's time and advice. They basically do their homework well. And well in advance.
The success of the high-end business outsourcing model depends not only on the execution abilities of the provider but also on the extent to which the client is involved. That high-end outsourced services are complex is a no-brainer. However, what is not often appreciated is how overwhelming this can be if either of the parties does not understand the brief clearly. In other words, if they do not get on the same page, pretty soon outsourcing becomes a big headache for all concerned. Typically, high-end outsourcing requires high engagement and active client involvement in the initial stages. This effort must be seen as an investment for, if done well, the benefits are long-lasting. Since such projects are iterative and require continuous involvement and communication from both parties, this investment is worthwhile. Shying away from this would imply lack of seriousness and the project would be doomed from the start.
All outsourced projects involve confidentiality issues; high-end projects, more so. For, chances are, the outsourced partner will be working with client's proprietary information. In such cases, a mere service level agreement that alludes to respect for confidentiality is not enough. It must be enforced, tracked and monitored for compliance.
Outsourcing will grow
Given the fact the buy-side firms must generate super-returns for their investors in an increasingly competitive, globalising and compliance-driven world, it makes sense to use an outsourced partner as an ally. Today, research providers such as Aranca have invested heavily in building capability, hiring and training talented analysts, understanding the implications of regulations as they come and cutting-edge technology platforms. They have perfected processes that ensure confidentiality, security, quality and timeliness of delivery commitment. The opportunity to forge relationships with such mature partners has enabled many buy-side firms to reduce operational risk to a great extent. Fund managers can use outsourcing to reduce their research burden and focus on what they do best – making money for their clients!
