Monday, January 6, 2014

"sell side" vs. "buy side"

"Sell side" is used as a catch-all description for firms that sell securities or investment research. Examples include brokerages such as Merrill Lynch and Smith Barney (subsidiaries of Bank of America and Morgan Stanley, respectively), as well as research boutiques following a given region or industry. "Buy side" is used in a similarly loose manner to describe organizations that manage other people's money, including trust departments, mutual fund managers, hedge fund operators, and other investment advisors. 

The terms themselves are hardly essential parts of an informed investor's lexicon, but fiduciaries intent on earning above-market returns would do well to understand the profound shift in the balance of power away from the "sell side" and toward the "buy side" that has occurred. The extraordinary profitability of leading sell side firms from the mid '40s through the late '80s can be attributed to two factors: their ability to attract and retain first-rate investment professionals and their capacity to furnish these professionals with the capital needed to serve as intermediaries in transactions between issuers and investors (i.e., underwriting) or investors and investors (i.e., brokerage). The "information revolution" spawned by semiconductors, regulatory reforms aimed at sanitizing pension and brokerage practices, and a host of other factors reduced the sell side's importance to issuers and investors alike and induced many of Wall Street's best and brightest to switch "sides": to leave senior trading or research posts at major brokerage firms in favor of principals' slots in money management boutiques. From a fiduciary's viewpoint, one salutary effect of this change is the increased availability of exceptionally skilled investors willing to manage endowment and foundation assets for a fee, often using strategies designed specifically to exploit constraints to which many buy side investors have historically been subject. The bad news, of course, is that the most able migrants from the sell side to the buy side command fees in their new positions that enable them to live in the manner to which they have become accustomed, forcing institutions to make painful tradeoffs between costs and expected returns.

Even if the tide that carried talent and capital away from the sell side reversed, it behooves all endowment and foundation investors to analyze carefully whether and to what extent they wish to pursue above-market returns. To invoke a baseball metaphor, it's unlikely that a minor league team could beat the World Series champion over an extended schedule, especially if the minor leaguers were precluded by law or custom from mimicking the champion's cleverest strategies and tactics. The minor leaguers would surely enjoy playing the world's best, but they would be ill-advised to bet much on their own triumph. Fiduciaries attracted by the market-beating returns that active management potentially entails must continuously ask themselves whether they have linked their fortunes to sufficiently skilled players, and whether they have given these players the managerial flexibility they need to play and win. One of the chief sources of profitability for sell side trading desks over the years has been their continuous — some would say ruthless — exploitation of legal or behavioral norms to which their buy side clients have traditionally been subject, e.g., buy-siders' favoring "on the run" (i.e., newly issued) Treasuries over higher-yielding but earlier-issued bonds of comparable duration. As more institutional capital flows into hedge funds and other vehicles that are free of such constraints, the market's overall efficiency rises. The inevitable result: even the best buy side investors have to run faster and faster merely to stay in place — refining or even discarding techniques that have worked well in the past but whose very success has reduced their profit-making potential.

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