ASIC researching the researchers

The financial relationships between fund managers and research houses escaped scrutiny in the most recent round of regulatory reforms. But that may not be the case for long, writes Lucinda Beaman.

The pay-for-ratings model, in which research houses accept payments from fund managers to subsidise the investment research process, has long been accepted in the Australian financial services market. In fact, it is prospering.

Some major movements in the clients’ books of research houses in recent months has meant that, for the first time in many years, the majority of Australia’s top-50 dealer groups now rely on research that is heavily subsidised by fund managers.

It’s a model the regulator has expressed concerns about in the past. During the Ripoll Inquiry, the Australian Securities and Investments Commission (ASIC) recommended the Government consider whether fees paid by product manufacturers to research houses should be reviewed.

In its submission to the inquiry, the regulator noted the common practice in the Australian research industry for researchers to be paid by product providers. This situation “creates an obvious conflict of interest and has the potential to distort the quality of research reports often used by advisers in making product recommendations to clients”, the regulator said. ASIC suggested a “user-pays model for research house remuneration might help improve the quality of the research used by advisers”.

The recommendation was not picked up in the resulting Future of Financial Advice package, but that doesn’t mean ASIC’s concerns have been forgotten.

The regulator has recently been in discussions with representatives from research houses and dealer groups to discuss issues, including business models, conflicts of interest, and disclosure and transparency in the research market, as well as the quality of research being given to advisers.

Treasury confirmed to Money Management that ASIC is “currently considering what measures (if any) it should put in place as a result of this work”.

It’s clear that for many of Australia’s top dealer groups, the potential for conflicts of interest in a pay-for-ratings business model is not a serious concern – at least not for clients of the most predominantly used research house, Lonsec. But there are also many who believe the model is not the best solution for the financial planning industry, or investors.

Confident or concerned about conflicts of interest?

The financial services industry is under pressure to restructure its business models to remove any potential for, or even perception of, conflicts of interest that could create question marks in the minds of existing and prospective clients. There are some who believe this restructuring should extend to the investment research industry, one of the most integral and influential sectors of the market.

“In an ideal world, there would be no subsidisation of the cost of investment research; it would be independent and based on a pure subscription fee,” Australian Unity head of financial advice, Craig Meldrum, said.

“The industry should be coming to the realisation now that there is a philosophical as well as a physical decoupling of advice and product. In that respect, the better the research and the more independent the research from the actual product you’re recommending, the better the outcome for the client.”

Matrix Planning Solutions managing director, Rick Di Cristoforo, is another who has concerns about any financial relationship between fund managers and research houses. In addition to an aversion to a pay-for-ratings model, Di Cristoforo is concerned about research providers subsidising the cost of research by offering funds management products, a model employed by the group’s former research supplier, van Eyk Research.

“We want clean research without product provision or without payments being taken from fund managers,” Di Cristoforo said.

“I don’t believe you can be a product provider and a researcher like that in the same entity. That was an issue for us.”

Other dealer groups, however, believe the potential for conflict in these business models can be adequately managed. Professional Investment Holdings managing director, Grahame Evans, agreed that dealer groups must be comfortable with the business models and research methods employed by their research suppliers, conclusions that can only be drawn after thorough due diligence is conducted.

Based on the due diligence undertaken by his internal research team, Evans said he’s “very comfortable” with his research partners (Lonsec, van Eyk Research and Zenith Investment Partners) relying on a hybrid fee model.

DKN chief executive, Phil Butterworth, is similarly confident. Butterworth believes there is an important distinction to be made between fund managers paying to be rated, and fund managers paying for ratings.

“The pay-for-ratings model … it’s not paying for the ‘right’ ratings,” Butterworth said.

There are significant-enough disincentives for researchers to avoid such a trap, Butterworth said, using DKN’s primary research supplier, Lonsec, as an example.

“If Lonsec give poor products good ratings, they’ll lose subscribers. If they lose subscribers, fund managers won’t require their research because nobody’s using it,” Butterworth said.

“As soon as they compromise a rating, they’ve just compromised their whole business model. They know that and I think that is a very powerful relationship.”

This is an argument Lonsec and other researchers relying on both adviser and fund manager revenue streams have sought to make to the regulator in recent years.

“We certainly have dialogue with Government when we have an opportunity. I know they’re still certainly interested in the sector and we have discussions on our model to make it clear how we operate,” Lonsec managing director, Grant Kennaway, said.

“The model is only as successful as the quality of the work you do. You can’t compromise on quality or integrity or making sure your research is robust, because the industry wouldn’t tolerate that.”

But for some, the perception of conflict can be just as concerning as the real thing.

RI Advice Group chief executive, Paul Campbell, said while he doesn’t believe the pay-for-ratings model necessarily leads to conflicts of interest or a poorer quality of research, subscribing to a user-pays model removes any question of those concerns in the minds of both advisers and clients.

“I think it does raise questions when you see where the research is being paid from. We’ve removed that conflict,” Campbell said.

“I wouldn’t stand here and say the research is unequivocally better as a result.

“But I think advisers need to know is that the researcher is acting in their best interests and not anyone else’s. That’s the key to it.”

Meldrum said his group would welcome a research industry in which “you could rely on knowing the research you are receiving is unblemished and not bent towards a particular message because one fund manager is paying more than another, for example”.

“We haven’t seen any example of that, it’s just one of those feelings in the industry, because fund managers are well funded and they do have a lot of sway with research providers, and some do take the cake,” Meldrum said.

He pointed to the fact that some researchers had “publicly stated that they do not accept the sometimes lucrative offers from some product providers to favourably rate their funds”.

When the reports generated by research houses shape the recommendations of the entire industry, “you can see why the fund managers are so motivated to throw everything they have at the research houses”.

“We know all the bells and whistles and salesmanship that goes on between research houses and fund managers and equities brokers and that sort of thing. We can’t be party to that, we need something that’s really open and transparent and independent,” Meldrum said.

“The industry has been open to criticism for far too long. Anything that drives professionalism, we’re very happy with.”

Di Cristoforo agreed that the pay-for-ratings model leaves the advice industry more vulnerable to criticism.

“Unless you charge the person that’s receiving the research, you’re always going to run that risk.”

Price pressures

One of the roadblocks to an Australian research industry founded on a subscriber-pays model is that many dealer groups and advisers aren’t willing to pay the full price of research.

“The Australian market, while it’s a strong financial services market, still doesn’t seem to be large enough for a pure subscription-only business to function without any other revenue streams,” Kennaway said.

The gap between what research costs to produce and what dealer groups are willing to pay “depends on what you’re trying to offer”, Kennaway said.

“We want to have a high quality and broad research offering. That’s an expensive business to run.”

Opponents to this argument say it is a poor excuse from advisers whose businesses, and the livelihood of their clients, lean heavily on the quality of investment research.

“I don’t think that’s a valid excuse for taking money from a fund manager. I think if people are going to have research, they should pay for it. It is intellectual property – if you want it, you should pay for it,” Di Cristoforo said.

Meldrum is another who believes advisers should be willing to pay for research.

“Research is absolutely necessary to what we do. We need it. And if it means paying more to ensure that our clients’ money is safe, then we’d be up for that, we’d do that,” he said.

“Professionalism and the best outcome for clients is what we’re all driven towards. If that means you’re looking at the research that’s out there and you’re going to get a better cost deal from one as opposed to another, and you have a feeling that the research you’re being given is not exactly transparent – and may be tarnished by fund manager subsidies, for example – then we’d rather pay more and have independent and transparent research.”

Campbell, whose advisers use Mercer as their primary research supplier, acknowledged that while subscriber-pays research is significantly more expensive than research subsidised by fund managers, he believes it’s a price worth paying.

“You’ve got to put in the appropriate amount of time and money to get good quality outcomes,” Campbell said.

Evans, meanwhile, argued that advisers, and their clients, should not be expected to bear the full cost of research.

“If you took away that payment from the fund managers to the researchers, what you’re going to end up doing is pushing that cost onto the client, in some way or another. It’s got to go down there somewhere. And I think the whole industry business model is under enough strain as it is without putting another cost onto the client,” Evans said.

“So I’d hate to see that go.”

Evans said while removing payments from fund managers to researchers might “completely remove any potential for conflict”, he considers it an unnecessary additional cost in an environment in which he believes any potential conflicts of interest are being more than adequately managed.

Butterworth also believes advisers should not have to bear the full burden of the cost of research in an environment where fund managers are just as reliant on research reports for their survival as advisers.

“There are two parties that rely on research. The adviser absolutely has to rely on research to ensure they’re investing their clients into the appropriate funds, but on the flipside, fund managers need their products to be researched to ensure they can get in front of an adviser,” Butterworth said.

“From my point of view, from a commercial point of view, fund managers are as much a user of research as a dealer group, so they have a responsibility for paying for their role in that. A dealer group also needs research, and they should absolutely be paying a commercial fee for accessing that.”

Meldrum acknowledged that while removing fund manager payments from the research value chain would “perhaps drive the cost of subscription up” for advisers, he said this would be a price worth paying for unquestionably independent research, and would “do so much to improve the advice profession’s view of and reliance on the research providers”.

And while the price of research subscriptions may be driven higher by a move away from a pay-for-ratings model, Meldrum believes this could lead to cost savings elsewhere.

“I think it would drive down [professional indemnity insurance] costs for the PI insurer to know that the research a licensee is depending on is unbiased and independent,” he said.

“At the end of the day, if clients are not happy with the advice that’s been provided – if you’ve relied on research that’s substandard for example – there’s the potential for brand risk, the risk of ASIC coming in … I think it’s a small price to pay for the benefit that you’re getting.”

Quality of research

Di Cristoforo believes a pay-for-ratings model does place limitations on some research houses, and their dealer group clients, by restricting their potential pool of research. Di Cristoforo said this can particularly be an issue where investments outside the managed funds space, such as direct equities and ETFs, are concerned.

Morningstar co-head of fund research, Tim Murphy, said Morningstar’s subscriber-pays business model means this doesn’t cause a concern for him.

“We determine what we do and don’t want to cover at the start of every sector review based on our own criteria, not based on what the fund manager’s marketing agenda is,” Murphy said.

“That’s meant that there are heaps of products that some managers would love us to cover that we haven’t, and equally there are products that we do cover that fund managers have not particularly wanted us to cover in certain circumstances. Our agenda is dictated to by what our clients and investors want or need, and not what fund managers want or need,” Murphy said.

Lonsec’s Kennaway argued his group is also focused on “meeting the needs of subscribers and focusing on the areas they want”. Kennaway said that while fund managers in traditional asset classes were being “more meticulous” in their processes before launching new products, there had been movement in other areas, including in the ETF and SMA spheres.

DKN’s Butterworth, with the significant pulling power of dealer group Lonsdale and his network of boutique licensees behind him, said he can influence product providers to pay for a rating from his preferred research house, or alternatively request the research house to examine a new product – although it’s a demand not all advisers are able to make.

For Campbell, committing to Mercer’s subscriber-pays model makes him confident the research house is focused fully on meeting the needs of its dealer group clients.

From Kennaway’s perspective, this “healthy competition” between different models in the investment research market is vital in ensuring there is “choice for dealer groups and advisers”.

“I think the market will allow models where they see their research provider adding value to their business and their clients,” Kennaway said.

“The market will judge what the right model is.”

But with ASIC making its investigations into the workings of the research industry, that decision may no longer rest in the market’s hands.