Financial services research: Doing your homework

In volatile markets that have delivered below par returns over the past couple of years, it may be difficult to see how there might be an opening for any new product in the Australian market and harder still to see why fund managers should go to the effort and expense of having products researched or rated.

However, financial planners continue to see clients, money continues to be invested into superannuation, research houses continue to make fund recommendations and provide asset allocation advice, and investor sentiment is improving.

What kind of role do researchers play?

Researchers provide a valuable role for the financial planner and for the fund manager.

For the planner, they help sort through over 13,000 managed funds that are available to the Australian investor. While investors, advisers, researchers and consultants will almost unanimously agree this number of funds is simply unnecessary, the reality is that the number isn’t getting any smaller.

New products continue to be developed and brought to market even in challenging times such as these. Financial planners still need to be on top of all new developments in the product space and they still need to be able to cite a level of due diligence on the sub-set of funds they are recommending to their clients.

By outsourcing this role to an independent research house or internal research department, they are freeing up more time to concentrate on client relationships.

For fund managers, the requirements of research houses provide a standard of information and accountability that provides an aspirational hurdle to entry for start-ups and ensures that the industry continues to maintain the highest professional standards.

One of the key benefits for financial planners and their clients of using independent research is the depth to which the research teams can go to give real insight into how a fund manager operates. Nigel Douglas, head of investment research at van Eyk, believes this is one of the key attributes of van Eyk’s research process.

“Our research is in-depth and is developed after a number of face-to-face meetings with fund managers. These meetings involve frank discussions and detailed questioning by our team. If we do not feel we are getting an accurate picture as to how the fund is run, we do not hesitate to make difficult calls to exclude the fund manager from review or to put the fund manager on hold until further information is provided.”

David Wright, director of Melbourne-based boutique research firm Zenith Investment Partners, points out that during the bull market phase of 2006-07, the old adage of a ‘rising tide raises all boats’ was largely true in that most managers were providing attractive returns.

This is no longer the case and there is now a huge dispersion of returns between managers. This makes the provision of quality research, in Wright’s opinion, even more important in being able to identify those managers most likely to outperform in current conditions and in a generally more difficult environment.

Douglas shares a similar view, saying “advisers can no longer rely on rising share markets to simply make their clients’ money. Instead, it takes judicious calls as to what asset classes to invest in at this time.”

The backlash

This is in contrast to recent opinions expressed after the global financial crisis, which suggested that researchers should be more accountable for their recommendations.

The Australian Government acted on this opinion, with Senator Nick Sherry (now replaced by Senator Chris Bowen) releasing a statement on November 13, 2008, which said: “The global financial crisis has prompted a global consensus for improved regulation of credit rating agencies, whose role has come under scrutiny due to their involvement in providing inaccurate ratings of structured financial products in the lead up to the US sub-prime loans crisis. Retail and wholesale investors in Australia rely heavily on information from credit rating agencies and research houses to make investment decisions, so they play an important gate-keeping role in the financial system and in the general level of system confidence.”

To this end, the Government is requiring all credit agencies and research houses to obtain an Australian Financial Services Licence (AFSL). The irony here is that while we agree that the actions of the Government can only be a good thing for the transparency and credibility of the industry, the reality is that independent research houses have always required an AFSL to operate. It would appear that research houses have attracted negative criticism by being associated with credit ratings agencies.

Nevertheless, research houses are not without their challenges in this environment. We go on to examine these challenges and how research houses are positioning themselves to deal with them.

The challenges for research houses

According to Grant Kennaway, general manager, research, at Lonsec, the role of research has been complicated by “both the proliferation of products and the proliferation of platforms in the Australian financial services industry and, in particular, the emergence of cut-down platforms such as mini-wraps”.

Perhaps muddying the waters further has been the emergence of new research houses over the past few years — for example, Zenith and Aegis, increasing the competitiveness of the sector. In addition, as financial markets performed well, many research house staff were tempted by big salaries on offer elsewhere, making it difficult to retain the specialist knowledge required to assess fund management operations.

While full disclosure has always been at the heart of the research process, Kennaway also rightly points out another complicating factor has been “the reluctance of fund managers to provide sufficient information, particularly where after-tax returns were concerned”.

There is also the ever-present threat of litigation from disgruntled investors and financial planning firms, which may pursue action over a single investment option, even though the broader recommended strategy has performed well.

In light of these challenges and increased volatility in markets, researchers are taking their own initiatives. Standard & Poor’s (S&P) Research has conducted a comprehensive review of the financial strength and corporate sustainability of fund management companies for funds rated by S&P Research. Leanne Milton, head of research, said: “While we normally assess business management as part of our ongoing reviews, we believe current circumstances demand an immediate and deeper investigation, ‘off-line’ from our normal schedule.”

Opportunities for investment managers and researchers alike

Upon reflection, all crises can create opportunities, and for the astute fund manager there are opportunities at present.

For retail investors faced with the cash rates of 3.25 per cent, rising cash rates seem to provide an attractive income and defensive option in a volatile market environment. This is especially the case as bond yields are likely to rise further (eroding fixed interest returns) and equity markets have enjoyed strong rallies this year. Furthermore, deposits remain government guaranteed for a period of three years, so investors may be reluctant to chase returns in fixed interest compared to previous cycles.

However, dividend yields (currently at 4.5 per cent) are still above the cash rate and, on a ‘buy and hold’ basis, sectors such as investment grade credit are likely to outperform cash, even if the cash rate reaches 4.5 per cent to 5.0 per cent.

Economic fundamentals imply that sustainable recovery will likely require a lengthy period of corporate and consumer deleveraging in nations like Australia with structural current account deficits. Such a phenomenon would clearly have a dampening effect on global economic growth, and consequently inhibit the performance of equity portfolios in the medium to long term. At the very least, equity performance is likely to be more volatile and less synchronised than has been the case over recent years.

On this basis, thematic products are popular, and there are a lot of these types of products available in the market at the moment. Some of the newer, open-ended forms of capital protection, for 75 or 80 per cent of the fund’s highest net asset value (NAV), can be well suited to thematic-style investments, especially where the timeframe over which that particular theme could play out is uncertain, and where the volatility of that theme, or of the index that provides exposure to the theme, is high.

Recent market volatility appears to have garnered two sorts of reactions from investors: the first is a flight to low cost, highly liquid market representation. Exchange traded funds (ETFs) have been capturing increased attention in answer to this. ETFs are essentially open-ended managed funds listed on a stock exchange such as the Australian Securities Exchange (ASX).

They are designed to track and provide the return of an index or investment strategy, which can be a common index such as the ASX/S&P 200, or a customised index that provides a specialised exposure such as emerging markets or commodities. Unlike listed investment companies, ETFs always trade very close to their NAV because there is direct access to the assets of the fund.

Alternatively, highly concentrated Australian equity funds that can take advantage of the higher levels of market volatility have also become popular as fund managers are given bigger risk budgets to take larger positions in stocks where there is strong conviction.

Wright’s view is that as a result of the financial market turmoil, all research groups will have a renewed focus on the liquidity of underlying assets in funds, gearing and leverage within products and avoiding very complex, non transparent structures. This should always have been the case, he says, but is now very much in focus.

The way forward

Whatever the asset class and whatever the bias of the planner’s clients, research houses play a very important role in the operation of Australia’s managed funds and financial market products. Understanding what researchers want is essential to your business success:

• maximum performance with minimal risk;
• to add value to a client’s portfolio;
• better than the incumbent; and
• consistency — marketing material, presentations, performance.

The way fund managers benefit from dealing with researchers is just as critical:

• objective assessment of your investment capabilities;
• support of your product made available to their clients — invaluable distribution; and
• keeping good company — small boutique players can be just as highly rated as large incumbents with huge resources.

Whichever way you look at it, your success and their success are intertwined. It is important that we work with them to achieve the best results for our industry going forward, not make them a scapegoat when times are difficult.

Amanda Rethus and Edwina Best are founders and directors of Gateway Financial Marketing, a boutique investment marketing company.