Researching the researchers

James Dunn
— 1 minute read
In trying to make sense of the crowded investment product market, advisers and dealer groups have traditionally outsourced the research function to specialist providers. But in the wake of recent high-profile manager failures, dealer groups are becoming increasingly aware a blow-up on the APL is their responsibility.
ralia has the most crowded funds management market in the world.

There are currently just under 11,000 individual managed funds on offer in Australia, among them 3432 investment trusts for general savings and investment, more than 4000 superannuation funds for accumulating retirement savings and nearly 3000 allocated pensions for income during retirement, according to Morningstar.

For a country with a population of just over 21 million, this gives us the greatest number of managed funds per capita in the world.

Compare Australia's 3432 investment trusts for 21 million people with the equivalent number of about 25,000 funds in the United States, which has nearly 15 times Australia's population.

And that number does not even begin to consider lending products, risk insurance products, agribusiness investments, reverse mortgages and the rest of the menu of investment products on offer to Australian investors.

In trying to make sense of this cornucopia of product, advisers and dealer groups have largely outsourced the research function to specialist external providers: Lonsec, van Eyk, Zenith Investment Partners, Aegis, Standard and Poor's, Morningstar, PIR and Mercer.

But in the wake of recent high-profile manager failures, such as Westpoint and Basis Capital, dealer groups are more uncomfortably aware than ever that responsibility for a blow-up on the recommended list is theirs.

"The reality is that from a legal perspective, while we can buy research in, and the research providers have a duty of care and responsibility associated with that, the buck stops with us," says Graeme Evans, managing director of dealer group Professional Investment Services (PIS).

And the conundrum for the advisory side, Evans says, is that the product menu is too large for the dealer groups not to rely on external research.

"Considering the extent of the funds management industry in Australia and the variety of products, it's just about impossible for a dealer group actually to do all of its own research without some input from research houses, unless you keep your product list very small. For bigger groups, it's not an achievable option because of the diversity of their client base," he says.

He says the problem is one of both number of products and complexity.

"There's no other market apart from the US that has the range of fund products that we've got. From a research perspective, if you just look at how many products there are, you've got to ask yourself, 'are the researchers researching all of those products?'" he says.

"It's not just the small number of research houses and the large number of products available that's a concern - it's the financial engineering that goes on around products these days. Fund managers are getting cleverer, and products that perhaps were not stress-tested have been stress-tested in real time. But we're supposed to be the bunnies that know the product.

"One of my big bugbears is the know-your-product rule. Advisers are supposed to know specifically what a product does, but the reality is that we're moving more to an advice-based situation, where the product that we provide is the whole portfolio picture going forward, and where the individual product is simply an enabler inside the whole strategy. But as it stands the regulator can grab a product that was put into a portfolio - which might have been quite a well-balanced portfolio - and because that product has failed, they can come at you because you didn't know your product well enough." Zenith Investment Partners principal David Wright says ultimately the adviser is responsible for the appropriateness of the product for the investor, regardless of independent research rating.

"That's the reality. In good faith we assess the product, and we issue a rating on it. Ultimately, we have professional indemnity (PI) insurance, but PI is not going to help us if we've been negligent in the way in which we carried out our research," Wright says.

"The researcher needs to demonstrate that they've gone through the proper due processes to arrive at the rating on the product. The adviser has to demonstrate that they've gone through the same process in terms of the application of that product to that investor."

Evans says it is frustrating to be in the position of largely relying on research groups.

"We have good relationships with our research providers, but one of the things that we would like to see is some form of performance analysis of them - who got the research right and who got it wrong," he says.

"How do we know how well the researchers have actually done? There's nobody marking their card.

"I know they're in a competitive market, but competition to keep them on their toes is a little different to marking their card to see whether they've been effective with the actual research. If they rate a product four stars or five apples or whatever, nobody is marking their card to say 'you only got 60 per cent of that right'."

But he says the reality is that dealer groups are "not going to put aside time and effort" to monitor that.

"It's a big worry for us: is the research process doing anything other than actually ticking a box to say that you've got external research?" he says.

"We can tick that box and feel good about it, but if something falls over, we wear it.

"While things like Westpoint and Basis Capital have been embarrassing for some research houses, the liability and the responsibility lies with the dealer groups. We're not 100 per cent happy with that. The research provider, which rated the product, is insured, and also, to be fair, its report is a snapshot in time. I'd like to see a bit more responsibility placed back on the fund managers about the performance of their funds."

A possibility is to consider "research by exception" and put more responsibility back on the fund manager, he says.

"Look at the flagship Australian equities funds: Colonial First State, BT and so on. Yes, they'll have performance variance, and a team might leave occasionally, but are they likely to be major disasters? No. So should we only do research based on exceptions rather than every product?" he says.

"Fundamentally, there needs to be some review of how we make research effective for everybody, otherwise we could end up back in the old days, into some form of tied-agency structure, where we only sell a very limited range of products."

Lonsec head of research Grant Kennaway says that even though most dealer groups retain a research function, the days of a dealer group doing its product research internally have gone.

"If you simply look at where the market's gone, the days of having a small number of vanilla Australian equity products and a few global equity funds and a few property syndicates are gone," Kennaway says.

"The market is far more complex now and there is a need for external resources to assist in sorting through what's on offer.

"A dealer group that tried to internalise the function would need some serious firepower. For example, our research team is 35 people. We're operating at full capacity at the moment and we need that size and depth and breadth. To try to replicate that internally is a big ask." He says a trend is emerging in which the dealer group research function is a "filter" between external research and the advisers.

"The internal teams are really a filtering overlay, tailoring things to certain adviser groups based on what platforms they're using and what special needs the groups might have," he says.

"For example, some groups these days are more focused on using the IMAs/SMAs [(individually managed accounts/separately managed accounts) and their internal people are more focused on that. Other groups might have more of a direct equities bent and they'll be focusing on that, so it varies from group to group. They're looking to pick and choose from what's available on the external research menu based on what their business needs are."

Wright says the dealer group research function is "more of an administrative-type" role. "I can honestly say that when we attend a fund manager research briefing, rarely - if ever - do you see dealer group research personnel there. You see all your competitors, but not the dealer groups. Although a lot of them have the title of research manager, to be honest, I think we're talking about a central point for receiving, collating and distributing external research."

Axa Financial Planning head of research Rob Thomas says viewing internal research as merely an administrative or filtering overlay is too dismissive.

Thomas says the internal research group puts the external research into context for the advisers.

"We have an internal research team and we use external research, and there's a place for both," he says.

"Our job is to get many opinions from the people selling us the product, from our customers on how they might use it, from the various research houses, and then pull it all together and draw a conclusion.

"It's not about whether internal research should replicate external research. We replicate some of the external research, but in other areas we don't. We could do some of it ourselves - for example, my team has met all the Perpetual portfolio managers - but we're just as happy to take the considered opinion of dedicated researchers whose job is to research Australian equities managers.

"If they say we're merely administrative, that's not quite accurate. I think I've got just as much number-crunching ability as the research houses. For example, we've led some of the market intelligence on the tax-efficiency of managed funds, and we're quite proud of that. In fact, we could say that the external researchers can be a bit naïve about the use of the products. They don't understand the context of the capital gains or whether the product is to be owned in super or in pension phase. We do, and we're accessible to the advisers - that's the key to the value of an internal team." AMP Financial Planning managing director Michael Guggenheimer says the external research should be viewed as an input to the decision process to put a product on the approved products and services list (APSL).

"We use three research houses, but we would never wholly outsource research, because at the end of the day, it's our processes and our governance structure that decides what goes on and off the list," Guggenheimer says.

"The research sits behind the product, and it's an important part of the governance structure: a product can't go onto the APSL without the appropriate authorisation process being undertaken.

"The research houses don't provide or cater for research on all aspects of the products and services that our clients require. For example, we have lending products and self-managed super fund administration providers on our APSL. Research houses such as Mercer, Morningstar, van Eyk certainly focus on important parts of the APSL, but they don't perform all of the functions that we require in terms of our APSL.

"At the end of the day, the planner still has to link that to the client to make sure that that's the most appropriate product to suit the needs and the situation of the client. So for us, it's got to be a combination - we'll seek information from research houses to help us, and they obviously assess and rate a universe of managed funds and products. We will use those services to assist us to complete our research, but there's a proportion of what needs to be researched that the research houses don't cater for."

The dealer group that has most fully internalised the research function is ING, which has its wholly-owned research group Financial Facts to provide research to ING-aligned financial planning dealer groups.

In fact, ING head of research Maggie Callinan says Financial Facts could easily operate as an external research house if it were not kept so busy by internal clients.

"We're an internal research team that does first-hand research for three dealer groups," Callinan says.

"We work very closely with the advisers, we answer their questions, we help them understand strategy and portfolio construction and products. We're researchers for the advisers. We don't do work for external clients, but we certainly have the structure to do so: we have an Australian financial services licence. The thing is, though, that ING has been so aggressively acquisitive [in dealer groups], we have more than enough clients without going anywhere."

She says, in supporting the ING-aligned advisers, Financial Facts is supporting advisers who are using Macquarie Wrap, Navigator, Asgard, MLC and so on.

"Because we're supporting the advisers using platforms, we're looking at 80 different fund managers. We've got to be across the whole investment universe, in exactly the same way as Morningstar or Lonsec or van Eyk does. We're working quite closely with the dealer groups but then bringing them objective research that is influenced by their strategic needs," she says.

Financial Facts is the only such structure in the market, she says.

"I don't know anyone with a structure like this. There are still internal research teams, but we're a big enough team to go and meet the fund managers ourselves and do our own reviews and present that research to the investment committees," she says.

"We only use external research in the case where, for example, we might have a client requesting four agribusiness products to be short-listed. It's an expensive structure, because you have to be across a lot of managers and products and that requires a big team. But for us, our client base has grown substantially over time also, so there's more people paying for us," she says.


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