These comments may seem a tad shrill, however, it is my belief that the research task within the wealth management industry is currently under resourced, under appreciated, over worked and under paid, and as a result, not delivering to the extent that it could be, or should be. I believe this to be the case, because in large part, many dealers see the role of research as a compliance function, rather than a unique source of competitive advantage. As such, the function is considered a ‘cost centre’ versus a ‘profit centre.’
As a result of this constant pressure to reduce costs, Research Houses, (rightly from a commercial point of view), have fund managers contribute to their revenue line by paying fees to be rated (more on that later), by building multi manager products (e.g. van Eyk; and that did not work out so well) or by bundling services (Ibbotson and Morningstar) for their customers. All of these responses, to my mind, are natural, in an environment where the owners of these research businesses (and dealers who purchase their services) are privately owned (other than in Morningstar’s case, which is listed on the Nasdaq), and keen to grow their own shareholder value.
But when not resourced well, the issues that have been highlighted at IOOF can emerge. We have all read the press about the issues flagged within their research department, which has forced their MD, Chris Kelaher, to front a Senate Inquiry, whilst another individual has had his reputation left in tatters. Meanwhile, PWC have 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 our very fine industry. But it would be folly to believe that the issues currently being investigated at IOOF, are not occurring elsewhere.
The issues highlighted in the case of IOOF may have come about because of the ‘cost centre’ mentality that is applied to the research role generally (e.g. did the research function expand to deal with the multitude of acquisitions?) Some other dealers groups that I know have less than two people doing full time research, serving 100s of advisers, and 10s of thousands of end clients, and they are under constant pressure to do more with less.
To summarise, provided below is my attempt to show the ‘flywheel’ in reverse in terms of the demise of research.
The Research Demise Flywheel in Motion
- Dealers do not see research as a source of competitive advantage – it is seen as a compliance function (‘cost centre’), hence, very few have enough internal resources to manage the sheer complexity of the research task described below, over relying 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 get fund managers to pay to be rated or build products – a flawed model – but what is their 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 – and I say this with the greatest respect, and with my economics 101 hat on, one of two things has to emerge. Either, the talent pool is of a lower standard (relative) 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.
But why should this component of the value chain have such poor economics, if we consider what role the research function fulfil? 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 RG175) and the list goes on and on. When we consider the tasks, we should all agree, that these are highly complex undertakings. It is little wonder then, that one such research head decided to outsource the completion of his Kaplan tests, to one of his minions (joke of course – I have often considered doing the same…)
Why must they do all of these roles? Because the law states that this is what they are required to do.
Welcome to the lightest read you will review this year: Regulatory Guide 79
Regulatory Guide 79 Research report providers: Improving the quality of investment research is a ripper of a read. The opening stanza begins, importantly, 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.”
Critically (and again, I am focused 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.
But as an industry, I doubt this function is well resourced from a HR point of view to meet the objectives stated above and to do the role justice, (and the org charts of the major Research Houses covering each asset class are not large), again, because of the ‘cost centre’ mentality.
As importantly, Regulatory Guide 175 (and this was nowhere near as interesting as RG79 – the key characters and the plot were not as well developed in my view…), 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.
The way I read this, is that, it is fine to partner with an external Research House to develop APLs etc, but that is not enough – the dealer is also “expected to make inquiries“. But many dealers have a very simple APL process from a product manufacturer point of view (no doubt supported by a dealer’s insurer) i.e. ‘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 the takeaways from RG79 and RG175? No your honour, it is not.
Ian Knox (a.k.a Socrates), the MD of Paragem, was recently featured in Professional Planner Magazine (‘Why consistent research governance is critical for licensees and advisers‘, July 19, 2015) on this very subject. To quote the article, ‘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,” [going on to say] that, “Part-time research is dangerous. Filtering it when you have suspicions about something is more sensible…I manage risks once [the products are] there.”
And thats the rub – part time research or indeed, not adequately resourcing the function, is “dangerous.”
Who is leading from the front in terms of research resourcing?
Amongst the gloomy outlook, there are many groups that have invested heavily in this important function. At the big end of town, groups like Perpetual and Westpac/BT have considerable teams. And at the smaller end, there are countless examples of IFAs who have appointed highly capable people to their ICs. Groups like Paul Melling Retirement Planning, WLM, Julliard, the IFAs in partnership with Select Investment Partners like DMG, Stonehouse, Profile and MGD, and those supported by Atrium, another well resourced team.
What is not surprising, given my knowledge of some of these groups, is that research is front and centre of their customer value propositions – it is not about compliance but central to advice and their revenue lines. In short, a ‘profit centre’ and a source of competitive advantage – their profitability would suggest that they are on to something!
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 to be rated – the industry needs to be rebased. Because the industry is subsidised in a conflicted way (although there is no evidence that this is leading to any negative biases), it can never charge the true cost of providing research, plus a margin, to its clients. 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 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 – it is my proposition, that it is,
- Thirdly, dealers should not be able to just rely on their Research Houses to fulfil this task (remember RG175 – hard to forget really). 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, and
- 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 Astrarra than invested) – those blows up that can kill reputation (hurting financially), result in customer exits (hurt financially), and result in litigation (hurt financially) etc. That is, moving from a cost centre mentality by providing hard data to show how valuable great research is, when resourced appropriately.
In conclusion – there are not enough human resources applied to research because the economics are so poor – this situation has been created by everyone trying to save money in delivering a reasonable service, resulting in Research Houses cross subsidising their pure function, alongside of dealers, who are also looking to save money in this area by “outsourcing” (abrogating) the research function.
In my view, it is time for change, and yes, that change may cost the industry more, but in doing so, it will lift the industry’s reputation. From a cost centre mentality, to a source of competitive advantage approach because, “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, Founding Partner