Yesterday I wrote about an EU regulatory movement to eliminate the use of soft dollars by investment managers–that is, paying for research-related goods and services through higher-than-normal brokerage commissions/fees.
Today, the effects of a ban…
I think the most crucial issue is whether new rules will include hedge funds as well. The WSJ says “Yes.” Since hedge fund commissions are generally thought to make up at least half of the revenues (and a larger proportion of the profits) of brokerage trading desks, this would be devastating to the latter’s profitability.
Looking at traditional money managers,
$10 billion under management
in yesterday’s example, I concluded that a medium-sized money manager might collect $50 million in management fees and use $2.5 million in soft dollars on research goods and services. This is the equivalent of about $1.6 million in “hard,” or real dollars.
My guess is that such a firm would have market information and trading infrastructure and services that cost $500,000 – $750,000 a year in hard dollars to rent–all of which would now be being paid for through soft dollars. The remaining $1 million or so would be spent on security analysis, provided either by the brokers themselves or by third-party boutiques (filled with ex brokerage house analysts laid off since the financial crisis).
That $1 million arguably substitutes for having to hire two or three in-house security analysts–and would end up being distributed as higher bonuses to the existing professional staff.
How will a firm pay the $1.6 million in expenses once soft dollars are gone?
–I think its first move will be to pare back that figure. The infrastructure and hardware are probably must-haves. So all the chopping will be in purchased research. The first to go will be “just in case” or “nice to have” services. I think the overwhelming majority of such fare is now provided by small boutiques, some of which will doubtless go out of business.
–Professional compensation will decline. Lots of internal arguing between marketing and research as to where the cuts will be most severe.
There’s a considerable amount of overhead in a money management operation. Bare bones, you must have offices, a compliance function, a trader, a manager and maybe an analyst. At some point, the $100,000-$200,000 in yearly expenses a small firm now pays for with soft dollars represents the difference between survival and going out of business.
Maybe managers will be more likely to stick with big firms.
If history is any guide, the loss of lucrative soft dollar trades will be mostly seen more through layoffs of researchers than of traders.
publicly traded companies
Currently, most companies still embrace the now dated concept of communicating with actual and potential shareholders through brokerage and third-party boutique analysts. As regular readers will know, I consider this system crazy, since it forces you and me to pay for information about our stocks that our company gives to (non-owner) brokers for free.
I think smart companies will come up with better strategies–and be rewarded with premium PEs. Or it may turn out that backward-looking firms will begin to trade at discounts.
you and me
It seems to me that fewer sell-side analysts and smaller money manager investment staffs will make the stock market less efficient. That should make it easier for you and me to find bargains.