Standing between financial advisers and the fund managers recommended to clients is a research function, either internal staff or outsourced to a Research House. However, this research work is often under resourced, under appreciated, over worked and under paid and is not delivering to the extent that it should be. Many financial advice groups see the role of research as a compliance function, rather than a unique source of competitive advantage, and the role is considered a ‘cost centre’ rather than a ‘profit centre’.
How fund manager research is paid for
As a result of this constant pressure to reduce costs, Research Houses have developed sources of revenue which potentially compromise their independence if not managed properly:
- They require fund managers to contribute to their revenue line by paying fees to be rated
- They build multi manager products (eg van Eyk, although that did not work out so well)
- They bundle services together for their customers.
All of these responses are natural in an environment where the owners of research businesses (and advice groups which purchase their services) are keen to grow their own shareholder value.
The issues that have been highlighted at IOOF’s research department can emerge when insufficiently resourced. These problems have forced their Managing Director, Chris Kelaher, to front a Senate Inquiry, whilst another individual has had his reputation left in tatters. PWC has been appointed (no doubt at vast expense, post facto) to review the total research function within IOOF. It’s a bad look, yet again, for a fine industry. But it would be folly to believe that the issues currently being investigated at IOOF are not occurring elsewhere. Did the IOOF research function expand sufficiently to deal with the multitude of acquisitions they had undertaken? Some other groups that I know have less than two people doing full time research, serving hundreds of advisers and thousands of end clients. They are under constant pressure to do more with less.
The research flywheel in motion
The ‘flywheel in reverse’ demonstrates the demise of research into fund manager abilities:
- Advice groups do not see research as a source of competitive advantage. Few have enough internal resources to manage the sheer complexity of the research task and over-rely on external Research Houses instead, who themselves are capacity constrained.
- The ‘cost centre’ mentality flows down to the external Research Houses who have to survive on wafer thin margins to deliver a reasonable service. To cover the bulk of their operating costs, they require fund managers to pay to be rated or build products. It’s a flawed model but what is the commercial alternative? This shrinks the product pool to only those managers who can pay, versus all managers that should be given a chance to be rated (after sensible screening).
- Because margins are so thin, one of two things Either the talent pool is of a lower relative standard because the Research Houses are competing for talent against higher paying brokers, bankers or fund managers etc OR, they can pay top dollar but have to have smaller teams. Maybe the answer is in the middle.
- The end result? Lower quality of research, in time, to the detriment of the end investor.
Why should this component of the value chain have such poor economics, if we consider the role the research function fulfils? In summary, they have to be across global and domestic political and economic issues, have in-depth knowledge of the multitude of strategies available to investors (especially so in a ‘best interests’ world), know everything there is to know about fund managers in real time, emerging themes, product structuring, asset allocation, asset class valuations, direct equities, have views on ETFs, ETPs and LICs, specific fixed income offers, offer model portfolios and APL assistance, respond to individual adviser queries, do one off consulting jobs, research products not on the APL (a requirement of Regulatory Guide 175) and the list goes on and on.
These are highly complex undertakings. Why must they do all of these roles? Because the law states that this is what they are required to do.
Welcome to ASIC’s Regulatory Guides
Regulatory Guide 79 Research report providers: Improving the quality of investment research is a ripper of a read. The opening stanza begins with the following:
“Research report providers are important gatekeepers, preparing investment research for retail and wholesale investors. The quality of this research has a significant impact on the quality of advice retail investors receive.”
Focussing on the lack of resourcing in this function at the industry level, the following is highlighted in the guide:
- RG 79.38 – The constituent parts of a high-quality research service are the human and other resources applied to the research task.
- RG 79.75 – As the complexity of some financial products increases, it is essential that research analysts have the requisite skills and experience supported by an appropriate level of supervision and adequate sign-off processes to produce high-quality research.
- RG 79.76 – Human resources are a key input to research report providers’ processes and output. Research report providers should allocate sufficient resources to support the effective performance of their research staff.
- RG 79.79 – To analyse financial products well, research report providers need to allocate appropriate resources to each research task. This includes allocating sufficient numbers of staff with suitable qualifications for the research task and setting appropriate timelines for the completion of tasks.
This function is not resourced enough to meet the objectives stated above and to do the role justice, and the organisation charts of the major Research Houses covering each asset class are not large.
As importantly, Regulatory Guide 175 also provides some important considerations:
RG 175.310 Advice providers often use research produced by external research report providers to identify products that may be suitable for their clients. This research may assist in the development of approved product lists or in the preparation of SOAs. Advice providers are expected to make inquiries and research the products that they give advice on.
So it is fine to partner with an external Research House to develop approved product lists (APLs) etc, but that is not enough. The advice group is also “expected to make inquiries“. But many advice groups have a simple APL process such as ‘If you have an investment grade or above rating from any of the major Research Houses, you can approach our advisers.’ Is this enough given the complexity of the task, and in light of RG79 and RG175? No, your honour, it is not.
Ian Knox, the Managing Director of Paragem, was recently quoted (‘Why consistent research governance is critical for licensees and advisers‘, July 19, 2015) on this subject:
“Paragem outsources its investment research to Lonsec, only accepting products onto its approved product list (APL) that are rated ‘recommended’ or higher by this research house. Investment managers with similar ratings from other research houses are not permitted automatic entry to its APL.”
Additionally, Ian then applies a ‘sniff’ test:
“My background, and time in the industry, allows me to have a little bit of a common sense ‘sniff’, if you like, around what’s right and what’s wrong … you get a few warning bells … Part-time research is dangerous. Filtering it when you have suspicions about something is more sensible … I manage risks once [the products] are there.”
Note that: part-time research or not adequately resourcing the function is ‘dangerous’.
Amongst the gloomy outlook, there are groups that have invested heavily in this important function. At the big end of town, groups like Perpetual and Westpac/BT have considerable teams. At the smaller end, there are examples of Independent Financial Advisers (IFAs) who have appointed highly capable people to their investment committees: groups like Paul Melling, WLM, Julliard, DMG, Stonehouse, Profile and MGD, and those supported by Atrium.
Where to from here?
- Firstly, for the good of the industry, and counterintuitively, for better economics, Research Houses should no longer be able to accept payments from fund managers. The industry needs to be rebased because it is subsidised in a conflicted way (although there is no evidence that this is leading to any negative biases). Having the function stand on its own two feet will focus the model on quality and the industry will know the true costs of providing such a service.
- Secondly, the industry should consider having an internal ratio of people devoted to research relative to the size of their financial adviser force (but with some scale benefits). As such, every time a major dealer purchases another dealer, the research function would no longer be an automatic ‘synergy’ benefit. These costs could be passed onto clients if the evidence that superior research is worth the money, and I believe it is.
- Thirdly, dealers should not be able to just rely on their Research Houses to fulfil this task (remember RG175). They should be required to employ their own teams, in line with the second recommendation. Where a dealer is small, it could work with other similarly-sized groups to pay for this function.
- Finally, the industry needs to do a better job of showing how great research has avoided many of the blow-ups (more groups avoided Trio and Astarra than invested).
In conclusion, there are not enough human resources applied to research because the economics are so poor. Everyone is trying to save money in delivering a reasonable service, resulting in Research Houses cross subsidising their pure function, alongside advisor groups, who are also looking to save money in this area by “outsourcing” (abrogating) the research function.
It is time for change and that change may cost the industry more, but in doing so, it will lift the industry’s reputation and become a source of competitive advantage. The quality of this research has a significant impact on the quality of advice retail investors receive. And who doesn’t want that?
Andrew Fairweather is a Founding Partner of Winston Capital Partners.