Research houses: does product expertise add up to advice know-how?

From

Dan Miles

Research houses add value, but when it comes to offering advice their impact isn’t always equal. Innova’s Dan Miles looks at the evidence.

There are few guarantees when it comes to investing, which is why research houses provide insight which promises to tip the odds in your favour.

While research houses are crucial to helping dealer groups and advisers make informed decisions, a number of studies also suggest there are limits to that advice.

As the service and product offerings of research houses expand over time, it’s more important than ever that investors understand just what those limits are.

It’s very difficult to consistently pick winners

Research houses provide ratings that determine whether a product is investment grade. Dealer groups and advice practices use this as a qualitative hurdle when assessing whether a specific product makes their approved product list.

While this process improves risk management, it doesn’t appear to translate into superior investment performance. It has helped the vast majority of financial planning groups to avoid most (but not all) fund blowups – which is clearly a value-adding service.

However, evidence increasingly shows that highly-rated funds are no more likely to outperform than moderately rated funds.

A recent report by the UK Financial Conduct Authority recognised the important role played by investment consultants but found negligible performance difference between their highly rated and non-highly rated funds, with funds in both groups delivering negligible outperformance.

Not surprisingly, these results received mixed reviews.

“The bigger investment consultants strongly disagreed with our finding that on average investment consultants are not able to identify managers that outperform, although a couple of smaller investment consultants agreed that consultants are not able to identify asset managers that offer better returns to investors,” the report said. “Instead, these consultants see the ratings and recommendation process as a form of quality control.”

Previous studies have also cast doubt on the ability of consultants to pick winners.

A 2006 study[1] found that van Eyk Research ratings between 1991 and 2003 did not identify a positive relationship between fund ratings and potential outperformance (although funds with a hold rating may have previously outperformed but some were closed to new investors).

That study also referred to the previous work of Blake and Morey (2000), whose ultimate finding was that “…ratings, at best, do only slightly better than alternative predictors in forecasting future fund performance.”

Research houses whose primary claim to adding value is their ability to pick active managers are playing a high stakes game of musical chairs. There may be a prize at the end for the managers selected, but there’s rarely one for the investor.

Adding value through asset allocation and risk management

Where does research best contribute to the investment process? The answer to this lies in what the evidence shows is knowable, which can stop investors wasting time focusing on areas that typically don’t make a difference.

Risk is the most predictable and important element given its propensity to destroy value as investors react to volatility or capital losses. What we mean by this is that it is easier to forecast the range of returns for an asset, their potential magnitude and their likelihood than a single return number itself. Forecasting long-term returns is more challenging but possible while asset class correlations are neither forecastable nor static.

While active management can add value, on average, active managers underperform (after fees) because for every winner there’s a loser.

Over the decade ended December 31, 2016, more than 80 per cent of international equity and Australian bond funds and more than 70 per cent of Australian equity and A-REIT funds underperformed their benchmarks according to the S&P Dow Jones SPIVA® Australia Scorecard.

And unfortunately, you can’t rely on research houses to tell you who the outperforming managers are going to be. This casts doubt on those research houses attempting to pick outperforming active managers to fill out their own portfolio offerings – at least consistently and on a risk-adjusted basis.

The end result is that asset allocation, if done properly and in a risk-controlled format, can add significant value. This will provide the best chance of achieving long-term goals.

Research houses can help determine whether an investment strategy is appropriate for a particular client segment. They can help assess manager strategies to ensure they meet minimum quality criteria and won’t blow up. This is a very valuable service and shouldn’t be understated.

But a great fund rating is unlikely to lead to great investment performance. There is really no investment tool that can reliably lead to outperformance over time, but Innova believe that you can stack the odds in your favour. You can do this by concentrating on risk management through an active approach to asset allocation. It certainly isn’t a guarantee of outperformance, but if you manage the risk appropriately it should help with something even more important – helping manage client behaviour, and whilst returns matter, behaviour matters more. Deep product knowledge is important, but it’s not a winning hand. The best bet is still a combination of proven investment experience and skilled portfolio construction.

Knowing about it isn’t the same as doing it.

But hang on, don’t Innova do the same thing as the Research Houses?

It is a common misconception that Innova choose active managers in an attempt to outperform the market in their portfolios, utilising the same qualitative techniques as research houses. In fact, Innova conducted their own research into the ability of research houses to pick winners, and we found results consistent with the studies cited above – so we asked ourselves, how could we be any better?

We determined that we weren’t. Instead, we focus on selecting active managers through a quantitative, risk driven framework to find those managers that can implement the investment exposures we want through our asset allocation framework. We’re agnostic on active versus passive, our quantitative framework does a robust job in framing the risk exposures we are targeting, and on average adds value over time by using both active and passive exposures. For those interested in implementing a similar approach, we took inspiration from Michael Furey’s Delta Factors, and apply our own proprietary scoring and assessment methodology to the outputs and components of the analysis.

By Dan Miles, Managing Director

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[1] Australia’s Retail Superannuation Fund Industry: Structure, Conduct and Performance. Adam Clements, Gemma Dale and Michael E. Drew. School of Economics and Finance. Queensland University of Technology, Australia. Published in Accounting, Accountability & Performance Volume 12, Number 2, 2006.

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