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February 1, 2011

Cover Story: Gotta Have It!

Research's Growing Importance as Commissions Decline

By John D'Antona Jr.

Research trumps trading. That's the reality facing trading desks in the current industry slump. Because assets under management have declined, as has portfolio turnover, the buyside has fewer commissions to throw around. Combined with rate pressure, that means money managers have been forced to reapportion their commission dollars between research and trading. After years of growth, trading is now getting the shorter end of the stick.

"If you don't have a research platform you're dead in the water," said Michael Darda, partner and chief economist at MKM Partners, a research and trading firm. "It's increasingly difficult to compete in this environment if you're a one-dimensional firm--that is, offering either only executions or research."


See Sidebar: Weeden Looks for Research Edge

See Chart: Weighted Average Commissions Allocated for Specific Services


U.S. equity assets under management tell the story. According to the Investment Company Institute, for the first 11 months of 2010, the total of U.S. equities invested was $3.93 trillion. That's up slightly from $3.57 trillion in 2009, but off sharply from $4.9 trillion in 2007 and $4.57 trillion during the same period in 2006, prior to the global economic crisis.

Correspondingly, total commissions have declined as well, according to estimates by Greenwich Associates. The consultancy estimates that for 2010, aggregate commission spend was $10.5 billion. That's down 13 percent from 2009, when commissions were $12.3 billion. In 2008, during the financial crisis, commissions were at an all-time high of $13.9 billion. The difference between 2008's equity commission levels and 2010 is a staggering $3.4 billion.

The decline has affected all levels of the equities business, according to financial statements for the first nine months of 2010. In the bulge bracket, for example, Goldman Sachs reported a decline of 9 percent during the period in its equities commission revenue. Among regionals and boutiques--those highly dependent on research--Piper Jaffray reported a 15 percent decline in its institutional equities revenue. Finally, among execution shops, Investment Technology Group reported a 12 percent decline in the first three quarters of the year.

As a general rule, commissions are used to pay for both of the primary offerings provided by the sellside: research and execution services. Since 2006, the buyside has devoted more of its commissions for research. But during the financial crisis, this rise didn't affect brokerage firms because there was so much business being thrown at the Street. But now that business is down to 2006 levels, brokers are feeling the pinch--particularly execution-only brokers.

Because total commissions were on the upswing during the crisis, this state of affairs was good news for all types of brokers, including those who didn't provide research. But the situation has changed with the commission downturn.

An upcoming report from Tabb Group will show that 64 percent of buyside U.S. commission revenues were used to pay for alpha-generating ideas--research--in 2010. Conversely, only 36 percent of U.S. commission revenues were used to pay for execution-related services, such as algorithms and connectivity.