Investment Management to Radically Shift Over Next Two Years, Says TABB Group in “Institutional Equity Trading in America 2006: The Return on Relationship”

New York, NY - 24 October 2006

Competition for Alpha Redirects Order Flow, Consolidates Relationships and Reinforces Importance of Global Top-tier Brokers

Institutional Cash Equity Commissions to Decline by $1.7 Billion by 2008

Institutional equity commission revenues are plummeting, sales trading and research departments are being downsized and buy-side traders are opting for a self-directed approach to executing their orders. This is happening, says TABB Group in its newest annual industry research study, “Institutional Equity Trading in America 2006: The Return on Relationship,” as the once rock-solid bond between the buy-side and sell-side is morphing due to more directly accessible liquidity, less human interaction and fewer commission dollars changing hands.

However, while traditional long-only investment management commissions are declining, the total brokerage revenue picture is increasing as a growing number of traditional investment managers are looking elsewhere for alpha and launching hedge funds. As these managers start hedge funds, search for overseas opportunities and develop alternative-investment vehicles, their need for a global, multi-asset broker becomes greater. Additionally, the services these global brokers provide need to become more complex and sophisticated.

“Traditional investment management is dead,” writes Adam Sussman, TABB Group senior research analyst and report author, “in the sense that it is no longer useful to talk about traditional asset managers as one group and hedge funds another.” Instead, he explains, investment managers should be segmented four ways: long only versus long/short; broad-based versus narrow (sector or region); fundamental versus quantitative; and alpha seeker versus beta enhancer.

According to the TABB study, the bond between buy-side traders and sell-side sales traders has changed as increased regulatory scrutiny, a migration to lower, commissionable no- and low-touch channels and a realignment of sell-side services forced a drop in overall equity commission dollars paid, making it harder for brokers to know their clients and inspire loyalty. The result, TABB Group forecasts, is that US institutional cash equity commission revenues will decrease by approximately $1.7 billion dollars, or 6%, by 2008.

As traditional equity commissions decline, the rub is, says Sussman that the success of the buy-side is becoming more dependent on its access to other brokerage services such as global equity trading and research, derivatives, financing and deal flow. “As the importance of the interpersonal relationships is diminishing and commission dollars are dropping, investment managers are reducing the number of brokerage firms they use so they can allocate more commission dollars to their most valued providers. However, as the buy-side faces an increasingly complex world where liquidity, research and technology are not necessarily found at the same location, a more complex services and commission management mechanism needs to be developed.” He adds that this portends real change in the buy-side/broker relationship over the next two years as the buy-side realigns commission dollars, the number of engaged brokers and the percentage of order flow allocated to these brokers. This is what TABB Group defines as the “Return on Relationship.”

The increasing tension between trading and the brokerage business model is also affecting the move to electronic trading, as there is still a significant amount of large-block liquidity that is not electronic. Tapping into this liquidity will be critical for both buy- and sell-sides. Currently buy-side firms believe that internal and external crossing networks will be the best mechanisms to digitize this liquidity because it reduces market impact, exchange fees and execution cost. However, as the US market structure changes, the solution to tapping into this liquidity will change as well.

Additional findings and forecasts include:

• Over 50% of large, traditional, long-only investment managers have developed hedge fund products. In addition, 17% of all interviewed long-only managers that have not launched a hedge fund plan on doing so during the next two years.

• While 65% of long-only funds have no expansion plans, 31% plan to expand into Asia, 29% into Europe and 11% into emerging markets.

• Institutional investors are aggressively moving into equity derivatives as 67% of funds used futures, 64% options and 33% equity swaps.

• Full-service firms dominate buy-side commission flows, as 13 of top 18 brokers (ranked by commission flows) are full-service firms offering clients access to liquidity, research, corporate management meetings, capital commitment, new issues and more.

• 60% of institutional investors are covered by a commission recapture agreement. Over 20% of buy-side funds saw a decrease in commission recapture business while nearly double expect to see recapture decline further in the next two years.

• Buy-side traders are challenged by commission management with nearly one third of funds planning to add or upgrade their commission management software in 2007.

• Growth of trading algorithms is slowing as buy-side traders are only leveraging algorithms for 11% of their order flow compared with last year’s rate of 10%. Crossing network usage and growth, however, is more aggressive than projected in 2005.

• While the adoption rate of algorithms by the investment management community is leveling at around 80%, implementation-shortfall algorithms are now the most widely used category on the Street, a change from 2005 when VWAP reigned supreme.

The 66-page study summarizes conversations with head traders at 61 traditional asset managers handling aggregate assets under management (AUM) of nearly $10 trillion, covering the launch of hedge fund products to meet increased appetite for risk and diversity among their client base; equity derivatives trading; commission recapture; the use of trading platforms, algorithms and crossing networks in the hunt for liquidity; and the technological infrastructure that brings players together. Also featured are 56 exhibits including: institutional cash equity commission revenues per execution venue; top brokers by commission revenue; percentage of order flow to top brokers; percentage of order flow captured; software buying plans for 2007; change in broker relationships 2006 – 2008; and leading trading technology providers.

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