Australia’s next top model: advice-driven research

In a previous article, ‘A tough year ahead’ (Money Management, January 31, 2008, p12-14), I suggested that greater scrutiny of research houses was one of the key things to expect in 2008.

On May 22, 2008, the Minister for Corporate Law and Superannuation, Senator Nick Sherry, announced that the Australian Securities and Investments and Commission (ASIC) and Treasury would conduct a review of the regulation of credit rating agencies and research houses.

The financial services industry normally tiptoes around issues relating to research houses, at least publicly. But like some other parts of the financial services industry, the business models that have developed arguably have some flaws that may well be impeding the provision of best practice research and ultimately impacting the investment advice offered to clients.

Certainly, the industry has not covered itself in glory recently with some high profile product failures that were highly rated before their demise.

While some mistakes are inevitable in the investment business, perhaps it’s time to question whether the current business structures and incentives under which the research houses operate is appropriate for delivering the best outcomes for planners and their ultimate users, the investors.

Still, research houses are certainly not the only, or even the most significant, component of the investment industry, which has some real issues to be addressed to improve its image and operation.

It would also be wrong if research houses were overly burdened with blame for some recent problems. As an ex-researcher who knows many who have worked or are working with the research houses, I understand most of the issues and pressures they face.

Most researchers are well intentioned and it is the industry as a whole (planners, fund managers, regulators, platforms, and so on) that has contributed to the current position and operation of research houses and they should all accept some responsibility for any shortcomings.

Given the carnage in some clients’ portfolios in the last year and the profile some ratings and research houses have, it is no real surprise that they have been targeted for review.

While any specific recommendations are unlikely to be known for at least six months, the research industry should not automatically resist change when thoughtful change could actually be positive, potentially improving the quality of its output, its reputation and even (at least for the better ones) its profitability.

At the risk of oversimplifying things, there are two broad research house models that have evolved over time, although there is increasing crossover between the two.

There is the ‘pay for rating’ model (or use of those ratings) where the bulk of revenue is received on product reviews paid for by fund managers (although they would typically charge planners a nominal amount for product reviews and also offer other services).

Then there are those groups that primarily charge subscribers for research, although these groups also typically have multi-manager businesses. Some specialist independent research groups that only charge subscribers do exist, but they are a small part of the overall market.

This situation seems to have evolved out of the view that subscriber-based research is generally not sufficiently profitable to sustain a standalone research business. (I’ll come to the profitability issue again later.)

At first glance, the second model where subscribers pay for the cost of research seems preferred. However, one has to recognise that this latter approach also has some potential conflicts and issues relating largely to the allocation of research resources and the flexibility of the research house/multi-manager to make changes.

For example, how much are researcher resources devoted to the multi-manager side (which is usually more profitable) compared to the research side of the business?

Further, what happens if a particular investment manager is downgraded and needs to be exited? That is, when does the multi-manager implement the decision compared to communicating to planner and investor clients, especially as these can normally only move with a lag?

The latest Money Management Rating the Raters survey found that only 7 per cent of respondents believed that research houses offering investment management products did not create conflicts of interest.

In my opinion, these conflicts are probably manageable but not easily and possibly only in ways that somewhat curtail the flexibility of the investment management side of the organisation.

Even some research groups that historically used to be almost totally subscriber-based have increasingly developed relationships with some specialist research houses that are more in line with the pay for ratings model.

Therefore, let us concentrate on the pay for rating model because of its growing dominance and because I think it is where the greatest risk of a poor research outcomes lies.

It is simply naive to think that the act of fund managers paying for product research doesn’t influence the tone and outcomes of that research.

Indeed, in the Money Management Rating the Raters survey, 74 per cent of those questioned believed the payment of a fee could compromise the ratings provided (and these respondents were fund managers).

After all, if a manager gets a bad rating on a product, you can almost be certain they won’t be back with a cheque for the product next year, thereby damaging researchers’ revenue.

While researchers say they refuse to rate some products, I suspect only a handful of products suffer this fate given the quality of some that are rated. (And almost all that get to this stage get a reasonable rating.)

It is obvious that those groups that have more products to rate generate a lot more revenue for the research houses than others.

Groups that spin out a new structured product every few months are particularly attractive from a business perspective.

Indeed, with structured products, it doesn’t seem to matter how many additional costs and fees, as well as restrictions on access and inflexibility are added to the core underlying product (which may well be a quality fund), the end product ratings all seem to be much the same.

The incentive on the research houses is to spread their resources widely and cover as many products as possible. Inevitably the quality of the research suffers.

As a result, too much of what is produced out of research houses seems little more than an extension of the fund managers’ marketing efforts, churning out product reviews with limited original comment or analysis.

Perhaps this is why the fund managers are paying for it (and happy for the system to continue), but it hardly makes good research and may well be compromising the portfolios that clients are receiving.

The key to good investing is avoiding big mistakes. The current research system that will rate almost anything for a price offers little support for that goal.

It is true that product reviews are not the only way that these groups are earning money although it does dominate their revenue.

Increasingly, researchers are recognising that what planners and clients need more of is good portfolio construction and ongoing asset/strategy allocation advice and help to ensure portfolios are properly diversified. The greater focus on this area, which is typically paid for on a subscription basis, is welcome, although under the current system is likely to remain poorly resourced compared to product ratings.

Research needs to be about more than assessing the ability of a manager to manage a particular area or asset class. It needs to be less about product.

What planners really need is help in identifying how much they should have in a particular area (whether fund or asset class) for particular clients and how this should change over time.

Having 2 per cent of a client’s portfolio in one of the recent funds that ‘blew-up’ is a problem, but having 20 per cent is a disaster.

There is no point expending huge effort in identifying the best property managers and ploughing a big part of a portfolio into them at a time when these areas are excessively valued and at risk of much poorer performance going forward.

While all research houses seem to be putting more emphasis on this aspect recently with greater work on model portfolios, I would suggest the dominance of product ratings in the revenue split is seriously inhibiting this.

There are some other issues facing research houses in the current environment. Staff turnover in some cases has been clearly excessive and quite alarming. How can users (and even the fund managers) be confident that staff members have the appropriate skills to understand their investment strategy?

Indeed, it seems researchers are hired largely on their ability to crank out product research reports quickly. But is that the core competency required of a good researcher? In my view, it is analytical ability and the ability to think about investments in a broader investment context that is crucial. A big chunk of a good researcher’s time should be spent thinking and reading much more broadly than on the products they review. The current system does not make that easy.

Some research houses have actually been upping the cost of their product ratings recently.

This is somewhat surprising when you consider the flak they are facing over some recommendations and the high staff turnover. But it is less surprising when you realise that their ability to raise fees has virtually nothing to do with the quality of their research or the perception of that value from the end users, planners and investors. Rather, it relies on their ability to convince fund managers to pay the amount and the number of fund managers wanting reviews on product.

Surely research house revenue should be more closely related to perceptions of their research value, but that’s hardly likely to happen while fund managers are paying the bills.

In announcing the review, there was talk about “improving transparency”. What does this really mean? Too often it just means more disclosure, but perhaps we are getting to the point where more disclosure has failed as the ‘cure all’ for problems in this industry. Greater disclosure doesn’t work because: 1. People don’t read it; 2. They don’t understand it when they do read it; and 3. Even if they read it and understand it, they place too much faith on the premise that if the practice is allowed and disclosed then it must always be good for them.

There is no point trying to improve the transparency of something if the incentives in place are leading to poor outcomes (in this case, potentially poor product advice).

If end users are getting the wrong outcomes, it is the incentives that prompt researchers to act and their actions that need to be addressed, not the transparency of those incentives and actions.

In my view, the solution is for regulators to enforce strict requirements to ensure licensed financial advisers and other licence holders that are operating recommended lists and model portfolios of active fund managers and direct investments either pay for independent research or else ensure (and prove) that they have access to that research capability in-house.

Product research paid for by fund managers would have no place in such a model.

Given those stark alternatives, most planners and dealer groups would have no choice but to pay for independent research, and I suggest the quality of research would improve markedly over time.

The exception would be for those dealer groups that have largely or totally outsourced investment decision-making either to a passive approach or a multi-manager approach. These are legitimate business models for those that educate their clients although they need to be confident that they have asset allocation covered.

Those buying direct shares for clients also have some important questions to ask.

If they don’t have the skills themselves, can they simply rely on stockbrokers who themselves may be compromised through corporate relationships or the need to generate transactions? (Look at how widely recommended companies like Allco, MFS and Centro were.) At least there are some sources of independent advice here (albeit with mixed reputations).

It is interesting to look at the system in the US where retail qualitative research ratings on fund managers basically don’t exist. Unfortunately, this forces investors and advisers to rely more on quantitative ratings that are more backward looking and can encourage performance chasing. There is a sound place for objective qualitative research if done well, but the incentives need to be right.

Indeed, I know of some quality researchers who would much prefer to be paid solely by their users, primarily the planners, if they could be confident that they could run a profitable business doing so.

True impartial advice can only be expected to be given when one collects their own fees from their own clients.

The abandonment of the ‘pay for ratings’ model, if replaced by stricter requirements for licence holders to use independent research or build their own, could result in greater focus on quality research and the type of research that advisers truly need rather than the research that fund managers are prepared to pay for.

The better researchers would come to the fore, experience would be more highly valued and it would enable them to hire (and retain) better staff and attract subscribers.

Research under this system could be profitable if its value became properly recognised.

It would be another step towards a more advice-focused rather than product-focused industry, although other parts of the industry would still have a few more steps to go.

Dominic McCormick is the chief investment officer at Select Asset Management.