The biggest hurdles facing researchers

PortfolioConstruction Forum asked the research houses: What, in your firm’s view, is one of the big challenges facing the Australian funds research industry at present, and why?

Lonsec

The primary challenge for fund research houses is to ensure they get their ratings correct and to publish high quality and timely research supporting their recommendations.

The biggest challenge to the funds research industry, like a number of professional services industries, is to articulate the value of its offering and the positive role that research houses play in the industry.

Research houses have had mixed success in articulating their value to subscribers.

This is a key issue given research, by its nature, is labour intensive and costly to produce.

Much of the attention is focused on research house fund ratings, but the value added through research services such as asset allocation advice, model portfolios and thought pieces is often missed in the discussion around the cost and value of fund research house offerings.

At this time, many larger advice groups are embracing research, building up their in-house research teams as well as entrenching strong relationships with external research houses. However, some smaller practices and individual planners are less engaged with research providers.

Perhaps this dynamic is symptomatic of the broader issues within the different levels of the advice industry, including the impacts of Future of Financial Advice (FOFA) in relation to potential regulatory change, as well as ongoing market volatility.

This uncertainty appears to be impacting smaller advice groups the hardest. These are the groups where research houses can be best placed to assist in providing a value adding service.

Grant Kennaway is Lonsec’s executive director for research.

Mercer

One of the biggest challenges facing the funds research industry is building confidence among advisers so that they feel comfortable once again advising their clients to invest in the equities market and other growth investments.

Mercer is seeing a lot of risk aversion in the industry, with planners scarred by losses in the global financial crisis (GFC), attracted by high interest rates for cash investments, and wary of high fees for low performance. But shying away from growth investments such as equities makes it harder than ever to deliver returns for clients.

Moreover, there are ways to effectively manage and investigate risk in the market while still generating returns above inflation and cash in the medium term. We would like to see greater awareness of these approaches in the retail investment market, as well as more development of suitable products based on them. These include:

• Low volatility investments: the safe end of the market. A low volatility equity strategy plays an important part in portfolio construction by helping to moderate risk levels – particularly in a portfolio with exposures to more volatile assets such as emerging markets and small cap equities.
  These ‘low-vol’ stocks are generally good quality companies in mature industries, with little or no debt, and a strong track record. The concept at work here is that these stocks win by not losing. Even though they’re unlikely to generate high returns in a rising market, they’re less likely to fall as far and fast when the market declines, and they benefit from the flight to quality investment behaviour during periods of market stress. Over the long term, this lower volatility counterbalances the higher volatility of growth investments.
• Indexation: an index-tracking investment based on market capitalisation, while traditionally favoured, may not always deliver on strong returns. These investments are susceptible to backward-looking bias and can be overweight in certain company stocks. They can also be prone to asset bubbles. That’s not to say that the idea that market capitalisation-weighted indices should be ignored altogether, but Mercer believes there are better alternatives to the market-cap approach. Market cap-weighted indices assume the value of a company based on the number of shares multiplied by the price of those shares – but we all know shares can be mispriced, driven by ‘animal spirits’ rather than rational investors assessing the underlying value of the business. 

The answer is to construct an index of shares that does not use the market price of those shares as one of its inputs.

The alternatives to market-cap or price-based approaches seek other, more stable measures of the true value of a company and use these value-weights as the basis for index-construction.

Gross domestic product-weighted indices are one option; another is to size each company according its fundamental value rather than its share price.

A value-weighted approach overcomes some of the more serious flaws of the market cap-weighted index, and investors should give serious consideration to managers who provide such an alternative.

Ultimately, advisers can’t avoid growth investments forever if they want to deliver growth and diversification to their clients.

However, there are strategies they can follow to manage the risks that are associated with growth investments, and Mercer would like to see more of these options being offered to the retail end of the industry.

Luke Fitzgerald is Mercer’s principal for wealth management and investment consulting in Australia/NZ.

Standard & Poor’s

Along with the force of change wrought by the GFC, the well-publicised Future of Financial Advice (FOFA) reforms and the proposed commissions and volume rebates ban are driving a variety of responses from the wealth management industry. These reactions include:

• The concentration of distribution, with marginalised financial planning groups swallowed by larger groups, and platforms rationalised;
• Increased vertical integration of financial planning groups to include platform and/or product to capture or retain margin;
• Shrinking of Approved Product Lists and more business being driven through multi-manager products and centrally-designed model portfolios to better manage risk;
• Increasing infatuation with cheap beta through exchange-traded funds and more direct control through separately managed accounts and direct equities;
• Growth in internal research teams, after recognising that the ‘know your product’ responsibility rests with the licensee; and
• Continued pressure on vendor fees, including third-party research houses.

In Standard & Poor’s Fund Services’ view, the single biggest issue facing the Australian funds research industry is how these industry dynamics will ultimately affect the competitive landscape for independent providers of research – and more specifically, how third-party research houses need to evolve to remain differentiated, high-value and competitive.

Possible ways that research houses can change and adapt to add more value include:

• Reducing qualitative fund coverage if fewer investment products are in demand;
• Improving depth of analysis, ideas generation and monitoring, including more timely research, better alerting of changes, more contextual information around investor suitability, more targeted model portfolio solutions, and better ways to electronically deliver content so it is embraced by users;
• Extending and deepening risk analysis, including operational and counterparty risk;
• Improving the engagement models with financial planning businesses to eliminate obvious overlaps with internal research teams, filling important analytical gaps, addressing new requirements, and helping those teams better service their adviser base;
• Expanding services to accommodate the trend to beta and direct investment;
• Providing more broad-based consulting services, moving beyond investment strategy to include business strategy, product construction, and risk management as financial planning businesses re-set their client value propositions, and
• Building stronger separation of cross-subsidising business lines where they exist (eg, ratings, investment advice, investment product, data and tool services) to improve transparency and analytical objectivity, and removing the lingering perception of conflicts of interest.

On balance, the need remains for a robust, independent third-party funds research industry.

As many of the wealth management industry reactions noted above could be described as premature, unresolved, or transitory, we believe that the path ahead for research houses – much like the financial planning industry – will be clearer once the FOFA reforms are legislated.

Still, in our view, wealth managers and their clients will always seek and pay for investment research that drives performance and/or provides deep insight, both of which are essential to the investment decision-making process.

Throughout the history of the capital markets, money-making ideas are front and central to success.

Mark Hoven is the managing director of Standard & Poor’s Fund Services.

Zenith Investment Partners

Having worked in the retail research industry at multiple research organisations over the past 20 years, I believe the biggest challenges faced by the research industry remain the same: firstly, maintaining a sustainable business and business model, and secondly, attracting and retaining experienced, qualified and highly competent research analysts in order to provide financial advisers with quality research and investment ratings on investment products.

On the first point, while there has been much media focus and attention on the business models of retail research providers – and, to a lesser extent, asset consultants – one only has to look at the two business models used by the research industry to recognise that an investment research business cannot be sustained on a user-pays model alone. 

The first business model, which is most popular with institutional asset consultants, is operating implemented consulting or multi-manager investment products alongside investment research.

In this model, research ratings and/or consulting services are sold to institutional investors such as corporate superannuation funds while the output of the firm’s investment research is also used to construct multi-manager funds for investors – including the firm’s research subscribers – to invest in.

This model allows the asset consulting or research firm to generate management fees from the multi-manager products, which are a percentage of the funds under management in the funds.

This model has potential conflicts which must be managed, such as an incentive to provide managers with strong investment ratings where they agree to manage money cheaply for the multi-manager business, or providing research subscribers with free or discounted research for a predefined level of support (ie, investment) in the multi-manager products.

The second business model is more popular with retail research providers where a component of their revenue is derived from fund managers.

This may be in the form of charging managers for product ratings, for fund data services, for advertising and promotion of ratings, or for attendance at research firm conferences.

Again, there are potential conflicts of interest that must be managed with this business model (such as providing favourable ratings to managers who subscribe or pay for the services).

In both instances, it’s important to understand that these business models are effectively subsidising the cost of financial advice to the consumer.

The reason for this is that in a true user-pays system, advisers would be charged more for research services in order for the research business to be sustainable and a going concern – the increased cost of which would ultimately be passed on by the adviser to the consumer.

While there is no doubt there are potential conflicts of interest with both business model structures, the reality is, if research firms provide poor research and strong ratings on weak investment products, advisers will not subscribe to that firm’s research and the business would ultimately fail.

In my experience, the second biggest challenge is attracting and retaining experienced, high quality staff in order to produce quality research and ratings for advisers.

The financial services industry is a highly paid industry, and research businesses compete with fund managers and other parts of the industry for talent.

In particular, it can be difficult to compete with the salaries and other incentives offered by fund managers to experienced and talented financial services professionals for investment personnel and business development roles.

The retention of quality analysts remains a very real and constant challenge for research businesses.

David Wright is the director of Zenith Investment Partners.

Van Eyk

Van Eyk did not provide an appropriate response to the question.

Morningstar

Morningstar did not provide a response to the question.