Monday, May 16, 2005

Yesterday's "Tip of the Day" was a post by HedgeFundGuy on soft dollars and hedge funds. I linked to it because I went to school with a lot of people now doing market research and analysis, and what he had to say about soft dollar transactions -- in which, as he puts it, the buy side "pays for things like research, ideas, and IPOs, via overpaying the 'sell side' ... to do their trades" -- seemed like a fairly well-reasoned argument against what many of those classmates do. So sorry guys. For those of you researching for a large brokerage firm, I'm onto you.

That said, the reason I'm writing now is that after thinking a little more about the issue this afternoon, I think the research industry in general is more valuable than HedgeFundGuy lets on. Consider, for example, his conclusion:

As per whether research is worth it, I would say that it has always been a mystery why anyone with profitable investing ideas would sell these ideas rather than just use them. Sure there are those without access to capital (as I was for many years), but in general the best way to profit from proprietary ideas is to approach a capital provider, provide them exclusive access to these ideas, and then after proving yourself and gaining credibility, negotiate a portfolio manager role (which implies direct control and payout link to profits). It just is not credible that much valuable research is being sold. I rather think that most research merely allows fund managers to better articulate their preexisting inchoate ideas, and some research provides ideas for brain-dead portfolio managers that should not be portfolio managers.

Admittedly, he nails it here a) when it comes to those without the capital necessary to directly profit from their research, and b) when it comes to fund managers who either are not qualified for their positions or are using the research they purchase to confirm conclusions rather than form them.

However, there's two huge instances that he leaves out. The first is when research can be used by multiple parties without affecting the profitability for any of them. Whether or not you yourself use your research, there's no reason to sit on it if you can sell it to someone else who's also able to use it.

The second instance, meanwhile, has to do with research whose value is variable. Consider the following example. A fund manager, Mark, pays both Sarah and Dave a marginally higher amount for their research than either would make if they used their research directly. Why does Mark do this? Because when he uses Sarah's and Dave's research jointly, he is able to make a greater profit than if Sarah and Dave each used their research alone and then combined their returns. In this example, then, the research market provides the altogether legitimate service of creating value where it otherwise wouldn't exist.

Of course, that's also an overly simplified example, and worse, it's further true that a market structured in this way will invariably lead to some blind speculation. But my point is that HedgeFundGuy should have brought it up nonetheless because -- provided the interests of the buyer are credible -- it's a perfectly valid role for financial researchers to play.

Finally, a brief disclaimer: for the less numismatic-minded among you, rest assured that this post was just a brief interlude from the normal social and political fare. When I went on a run this afternoon it just seemed like an interesting question to think about.


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