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The underfunded world of fund manager research

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:

  1. They require fund managers to contribute to their revenue line by paying fees to be rated
  2. They build multi manager products (eg van Eyk, although that did not work out so well)
  3. 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.

Rashmi H Mehrotra
August 05, 2015

Thanks for a good article, highlighting an important issue.

Having spent my whole career in research - at van Eyk and Mercer - my observations -

Yes research is under-appreciated but it had a number of people who cared about doing the right thing than making lots of money; I was fortunate enough to learn this from Stephen van Eyk

Van Eyk's demise may more to do with mismanagement and incompetence than business models. It was working fine when I was single handedly looking at the structured products and Stephen was running the business. As a shareholder from when Stephen first sold his shares to staff, and now seeing my shares goes to zero, I have learnt about the importance of people.

What's wrong with multi-manager funds if you are still on the client side of the table? It's actually a live performance track record of the research. If the fund doesn't perform, the research was no good. I don't get research houses or media publishing ratings/lists without ever calculating performance of those ratings.

Speaking of business models, how come the credit ratings industry survived the pay-for-ratings model when there was even admission of conflicts and incompetence? I have published an article 'Role of credit ratings' on what came out of the lawsuits against credit rating's shocking.

Part of the problem of under appreciation is inadequate education and training at the adviser level. They don't seem to understand the difference between alpha and beta, and expect perfect forecasting from their researcher. This is why I have moved from research to education. Advisers shouldn't really be advisers if they don't understand basics of finance.

I have also come to realise it's better to teach people what questions to ask rather than give a final answer derived from a black box rating process. It's more cost effective for a research house too...again why I am launching a research/due diligence portal with questions rather than answers.

Research fulfils an important role in captal markets. Let's figure out better processes and business models.

Steve Romic
July 31, 2015

Andrew, your article suggests that Investor/client interests are generally subordinate to commercial interests's hardly a surprise that the industry finds itself in this position.
In response, investors are increasingly becoming self-directed, while more and more Advisers are using passive investments, with some form of (outsourced) active asset allocation mechanism. Whilst these responses may not necessarily be ideal, they’re reasonable default positions, requiring much less resources.
A growing number of IFAs invest a large proportion of their revenue back into their own research efforts (including perhaps some of those referenced by you), which is a clear indication of their client-centric values. There’s no doubt that such groups are genuinely leading the industry charge … it just needs more of them.

Michael Furey
July 31, 2015

Andrew...thanks very much for your article. You've raised many important issues of an essential function that have rarely had the prominence they deserve. Well done.

July 31, 2015

I asked a fund manager when was the last time he/she had rewarded (financially and in surveys) in proportion to the quality of research, and if he/she was prepared to pay in proportion to the quality of research i.e. 5% of the upside (including the ones that end up being wrong). The logic was simple: create a win-win, and which would be obviously better than paying 20bps on something that halves in value.
Let us (NOT) discuss how many might be keen to take up the offer. As Mr. Packer (Snr) used to say, if you pay peanuts,......

July 31, 2015

Hi Giselle

Andrew here - the article's author - Winston has no current relationship with Select (has not had one for over 18 months), and at the time I wrote the article, I was unaware that Chris Cuffe has a relationship with Atrium (but I do now).



July 31, 2015

may I also suggest it is remiss of you not to state your interests, Atrium is now associated with Chris Cuffe and Winston is a preferred service provider to Select. To state that these are therefore ' well resourced' and therefore implicitly recommended is a conflict of interest. Im interested to see if you are prepared to publish this.

Jerome Lander
July 31, 2015

Very good article Andrew. Unfortunately research is not valued enough by the market or seen as a value adding activity, and this is what causes the problem. Far from being a compliance function, research should be about deep due diligence performed by experienced individuals focused on the best areas of investment opportunity and capable of making genuinely value adding decisions in the context of a portfolio's objectives. Unfortunately this is more expensive, is inconsistent with the status quo, and therefore not done by the vast majority of the market.

The reality is that much research conducted these days is not particularly helpful in an investment context, tends to support highly established strategies at the wrong end of their life-cycle from an investment point of view, and is biased towards past performance. Very little research is conducted on the most value adding opportunities and strategies that originate from investment managers - these are almost routinely not considered by most broad based research providers. Indeed, if you want to add value from manager selection, you better be thinking outside the square and prepared to do things differently from most.

July 31, 2015

This is a vexed issue with many counterparties. Start with the product providers who are essentially required to have ratings to make their way into self /advisor directed investors. Otherwise who can provide the appropriate level of due diligence? Should the internal research department? Of course, but as you state there are so many funds across asset classes that it is nearly impossible to cover all, and the cost would be large.
If rating houses no longer accept payment payments, would it then not be appropriate for the fund to reduce their fees given they will not be paying for such ratings? The problem is that these are mostly a rounding error for large funds, while for emerging fund may be quite substantial. What if funds simply chose not to provide data?
In my view the rating organisation work hard to prevent conflict of interest, and there is no reason funds should not pay some of the work involved. That said, relying only on ratings largely fails the client and their organisation. The method of rating is obscure - a secret sauce of factors weighted according to them. If one wishes to apply a greater weight to downside risk or fees, one cannot do so.
Substantial issues resides within funds themselves. Many (not all) they treat non institutional investors as a source of high margin profit, even though these are often long loyal and low cost to service. The fee disparity is a major unspoken issue, in particular performance fees and how they are calculated. They provide little disclosure on the performance and attribution - usually a lame this went up, this went down, two pager, which tells one nothing at all. and many more.
Before you castigate those that have to look in the eye of the investor, the funds industry should have a good look at itself.


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