Judge or be Judged

The value of analysis undertaken by investment research houses is currently in the spotlight, prompted by the deplorable performance of United States-based ratings agencies in the past few years.

One of the consistent failings of these agencies, and of the investment banks that packaged up high risk loans into supposedly lower risk products, was the failure to recognise that economic and market conditions can change dramatically in a short amount of time. Thus, the ratings used to assess products became completely inadequate when the risk of the underlying sectors changed completely.

This can also be said of the ratings used to assess managed funds products in Australia.

Most investors understand (or should understand) that when you are analysing the future, you are not going to get everything right — that is what taking on increased risks for higher return is all about. Making a decision to invest in a financial services product is going to involve assessing a number of different factors to try and reach a sensible investment decision:

1. The market itself — should you be there at all?
2. The sector — is it high or low risk at the moment, and is that risk increasing or decreasing?
3. The product portfolio — is it high or low risk relative to others, is the portfolio changing, will it perform in expected conditions?
4. The fund manager — do they have the expertise and resources to manage the money efficiently, is their process and style suited to expected conditions?

The latter area can be the least important investment element when markets are at turning points.

The analysis needed to answer all of the above questions across 28 asset classes and hundreds of fund managers is obviously extensive and needs to be ongoing. A number of observations for investors and financial advisers can be made at this point:

1. No simple one-dimensional rating can cover all of the analysis; it needs to be broken up into a number of risk categories (eg, risk of market, sector, fund manager, portfolio) and return categories (forecast alpha, variability, and so on).
2. The information should all come from the same source if possible, since the same underlying assumptions need to apply across the board.
3. To use the analysis effectively, the financial adviser will need to spend time assessing all of the information on a regular basis. Financial advisory firms throughout the industry need to have regular investment meetings to discuss investment research. Organising a phone link with their research house will assist in identifying possible risks in their portfolios.
4. Recommended lists of products need to be pruned down to quality (best of the best) products to cover the sectors. If this is not done, the risk of ongoing monitoring of lists will become impossible and mistakes will occur that could have been prevented with more diligence. This is a major failing of some large institutions who try to be all things to all people.
5. Research houses should provide the full gamut of investment analysis, not just churn out ratings that cannot possibly result in sound investments performance overall.

Investors need independent analysis across the board, and too often are swayed by fund managers whose objectives may be different from their own.

However, research houses will need to employ business models that encourage broader analysis, and discover investment themes that add value. For instance, trying to rate every fund manager in the market on investment capability will surely distract from their ability to firstly, provide ratings that are differentiated and secondly, put them in the context of broader investment issues. Monitoring of fund managers and financial products is also important.

The sources of revenue research houses receive need to be extensive enough to encourage broader analysis and not just the mindless production of ratings.

Research houses should be judged over time by the number of investment insights they generate that make money relative to those that don’t make money for the retail client. In difficult times they should also be judged by their avoidance of collapses or significantly underperforming products.

Financial advisers should put themselves in a position to make these judgements by firstly, a disciplined approach to analysing what they receive, secondly, by having a strong dialogue with the research provider and, thirdly, the efficient implementation of their decisions.

There is no way to make clients money without everyone in the chain doing their part.

Stephen van Eyk is managing director of investment research company van Eyk. He has worked in the investment research industry for over 20 years.