Sell Side Analysts Are Outsourced Buy Side Analysts

We read the other day about how Lehman is now moving some of its analysts to become "desk analysts", which basically means analysts who don't write research, but instead sit on the sales desk and pitch ideas directly to clients over the phone. Basically they will be the same as well informed salespeople. Many signal this as another signal telling us the end of sell side research is near. But we think there is more to it.

From DealBreaker:

A few years ago, when we were younger and stupider, we predicted the death of sell-side analysis (citing RegFD, access to data, etc) half-joking suggesting that it would be reclassified as "marketing". And then sell-side analysis stubbornly refused to die, much to our disappointment. But Paul Kedrosky suggests that the end is near and Lehman's already removing the feeding tube:

The post goes on to quote the website Infectious Greed (sounds like a great band name...) which argues that sell side analysts are basically just salespeople. Now true, we of course agree that sell side analysts are indeed salespeople. But what both of these sites fail to mention is that sell side analysts are also outsourced buy side analysts.

This is because buy-siders frequently get their sell side lap dogs to do a lot of work for them, especially if they are a favoured client. What makes this outsourcing especially appealing is the fact that it is a cost which is covertly passed on to the fund's clients. Using a "full service" broker means that a fund is accepting higher trading costs in order to get these "value-added services" for their clients. But of course the clients are the ones who pay for these services. Thus one can imagine that a fund could either A) hire more internal analysts and bear costs directly to its own P&L or B) hire less internal analysts and instead use higher commission brokers to do some of their work. Plan B incurs lower direct costs to the buy side manager's P&L. Either way, yes we understand that businesses always essentially pass on costs to clients in some form or another, but the difference here is that these costs are above what clients see as the management expense quoted to them. Its also labelled differently- as a trading expense when in fact any commission one is paying above the lowest discount broker, is truly additional management expense.

And as for these costs' visibility, sure the clients might lose a bit of performance through higher trading costs, but its probably pretty hard to notice. Especially if most other buy siders are doing the same then it just looks like a normal part of investing.

Thus we have a nice game whereby most major buy sider managers indirectly foot their own internal hiring costs onto their clients and sell side houses get to charge higher prices for a very basic, commodity service. (buying and selling stocks) Its a great deal for both sides really. Who loses? The clients. But its hard to notice, only a few basis points. And every "serious" money manager uses a "value-added" broker right? So even if your trading costs are higher, many clients also  probably feel more comfortable to receive their commodity buy/sell service from a flashy name.

Thus until there is more scrutiny from clients over trading costs, and the use of discount vs. "value-added" brokers, we don't think the sell side will quite disappear. Its too good a deal for both sides involved. We must say though that we have heard of some buy side managers feeling this pressure and just simply writing checks to sell side houses for services provided, instead of allocating trades. (as a method to fairly place the cost on the P&L) But its still in its nascent stages.

Comments

[Andrew Schmitt]

Great post.

Reminds me of the article in Saturday's WSJ about Oscar De Le Hoya and how he is changing Boxing by advocating full financial transparency to promoters.

I'm surprised the funds of funds haven't demanded the same. Maybe they will.

[The Other Stalwart]

Thanks for the comment. Yes, that is a good point. Funds of funds could be the first to drive change given that they have an interest in reducing the trading costs within the funds they invest in, and are conceivably more organized than individual investors.

[coach outlet]

Can share the pain of others, is a human; to share the happiness of others, is God.

[coach outlet]

Can share the pain of others, is a human; to share the happiness of others, is God.