Integrity at a price as researchers chase the dollars

Research houses have often been portrayed as the white nights of investing, standing firm as independent beacons of integrity between predatory funds managers and naïve investors.

However inThe Money Management Rating theRaters Survey, funds managers paint a picture of research houses as a group that is short on ethics, lacking in integrity and quick to compromise their own standards for commercial advantage.

In what is clearly one of the most poignant findings of the survey, 55 per cent of funds managers perceive the research process to be comprised by the fees they have to pay to be rated by research houses.

The concerns appear to be directed at the full spectrum of ratings houses, suggesting the up-front fees groups like Assirt and InvestorWeb charge managers to be rated, are as worrying as the fee structure of other groups like Morningstar, which get paid only when funds managers choose to publish their ratings.

“If a research group only gets paid by a funds manager if the manager publishes its rating, and the researcher knows that the funds manager will only publish high ratings, then there is a potential for bias,” one source says.

“Similarly, if you pay a fee to get rated and the rating comes out low, it is unlikely that you will pay to get measured again next year and that may be seen as giving the research house a bias to rank you highly.”

Just as alarming is the finding that the majority of funds managers (60 per cent of respondents), believe research houses are not held accountable for the ratings they actually hand down, regardless of the fees they charge.

The perception seems to have been fostered by what is seen as a general unwillingness on the part of research houses to submit their research to the same level of scrutiny that is often expected of funds managers.

For long time observers like ISG managing director Rob Keavney, the credibility of research houses has suffered from their reluctance to often establish a clear and public link between their ratings of managers and the performance of those managers.

“Each research house should publish regularly the average returns achieved by their various manager rating grades. If a research house thinks its research is superior, it should be glad to submit itself to this process,” he says.

Perhaps even more disturbing than a perceived lack of accountability however, is the perception that the entire business model of research groups may be riddled with conflicts of interest.

When a similar survey on research houses was published inMoney Managementin 1993, one of the main concerns expressed was that researchers often used a poor rating of a funds manager as a means to coerce it into purchasing other services from the research group.

The majority of respondents to the current survey felt all the research houses, except Morningstar, used their research on funds managers as leverage for other arms of their business.

Of all the groups, Assirt was seen as most likely to use its research to bolster its wider business interests (63 per cent of respondents). InvestorWeb followed on 59 per cent, with van Eyk and Lonsdale both on 53 per cent.

According to Keavney, the results could simply indicate strong recognition that some ratings houses are increasingly using their research as a key part of other products, such as software packages, which they on-sell to advisers and individual investors — a practice that should not create conflict of interest issues where ratings are concerned.

“There is some very poor quality research done in Australia these days, but I do not think it is as shonky a process as in the past, where other business imperatives took pride of place for some researchers,” Keavney says.

Nevertheless, it is undeniable that funds managers harbour a level of mistrust over the way ratings agencies conduct their business, and it is not surprising they have called overwhelmingly for research houses to be more open about their ownership structure and the factors that impact on their rating process.

Almost 87 per cent of survey respondents indicated it was necessary for the ownership and remuneration structures of research houses to be subject to more onerous disclosure laws.

A high proportion of those surveyed, just over 73 per cent, also felt research groups should be subject to much tougher licensing requirements before they are allowed to pass judgment on the relative merits of funds managers.

Overall, the findings demonstrate a widespread and often palpable sense of discontent amongst funds managers over the integrity of ratings agencies, the very attribute that should most clearly define research houses in the eyes of those who use and are subject to their ratings.

“The people who are there ranking us have a fraction of our knowledge and a fraction of our experience. It is like second-year university students ranking the professors,” one industry source says.