Regulatory Guide 79 Research report providers: Improving the quality of investment research (RG 79) has been updated to help research providers better comply with their legal obligations and to complement reforms under the Future of Financial Advice (FOFA) legislation aimed at improving the quality and accessibility of financial advice.

ASIC’s guidance applies to a broad range of research providers on investment products, such as research analysts, securities analysts or research houses.

The guidance includes measures to address:

• management of conflicts of interest, particularly business model conflicts among research report providers;
• quality and robustness of the research process including the need to allocate appropriate resources and expertise to the research task;
• transparency of the research process including the way products are selected for research, what ratings mean and how they are applied; and
• the ability of users of research to form a view about the quality and reliability of the research.

To assess industry’s compliance with the guidance, ASIC will conduct targeted surveillance of research report providers.

ASIC Commissioner, Peter Kell, said ‘In recent times, there have been serious concerns about the quality of research issued by research providers, particularly in light of various investments failures that had been rated highly.

‘Research report providers are important gatekeepers in the financial services industry, standing between product issuers and the investors who purchase investment products either directly, through advisers or through their super fund.

‘It is particularly important for research providers to manage conflicts of interest that may affect the ultimate research rating.

‘We have undertaken extensive consultation with the industry and broader investment community to produce guidance that will facilitate credible and reliable research but also makes clearer its limitations to the user’, Mr Kell said.

ASIC expects research providers to give clients or subscribers information to help them understand the research service. This includes the:

• methodology applied and any limitations that apply to it;
• process by which products are selected for coverage and filters applied; and
• spread of ratings (how many products or what percentage each type of rating received over the past year, for example).

This information is designed to help users determine the quality of the service and therefore, the extent to which the research report can be relied upon.

RG 79 also sets out ASIC’s expectations that research providers effectively manage conflicts of interest so as to limit their impact on the integrity of investment research.

Conflicts of interest that may affect investment research include:

• business model conflicts associated with, for example, an issuer pays business model; and
• conflicts arising from research providers’ other commercial activities. This includes non-research services provided to product issuers such as consultancy services, cross subsidisation arrangements, ancillary business units or funds management business arms.

In some cases, conflicts can be managed with robust processes and controls while in others, the conflict is so significant that it cannot be managed. In such circumstances, ASIC expects the conflict to be avoided entirely.

ASIC will conduct targeted surveillances of research report providers to assess compliance with this updated guidance, measuring both broad compliance as well discrete issues such as conflicts management.

‘If standards do not improve, ASIC will revisit the regulation of research report providers and consider whether specific law reform is needed’, Mr Kell said.

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This proposed segregation would involve strict and formal physical and electronic separation between ancillary business units such as consulting and funds management services and the research business.

A key conflict of interest issue for research report providers is whether providers should accept payment from product issuers to produce research about the issuer’s own products. ASIC is seeking feedback on whether these conflicts of interest associated with product issuers paying for research:

• can be effectively and robustly managed, or
• should be avoided entirely.

Consultation Paper 171 Strengthening the regulation of research report providers (including research houses) (CP 171) also proposes research houses lodge a compliance report every two years.

The biennial report would require research houses to address issues such as research methodology and processes, internal conflicts management procedures, conflicts disclosure to users, and managing research quality and transparency.

ASIC Chairman Greg Medcraft said research report providers are a significant gatekeeper in the market and it is expected they adhere to high standards of conduct.

‘Research can influence which products individual advisers recommend to their clients’, Mr Medcraft said.

‘As such, the quality of research and the conduct of research houses have a material impact on the integrity of the financial planning industry, and the quality of the advice they produce.

‘Research is an important consideration for ASIC in light of our priority to promote confident and informed investors.’

CP 171 follows discussions ASIC had with a select group of research houses, as well as financial planning and advice industry associations and a number of their members. ASIC also held talks with some industry associations representing other research report providers such as the Australian Financial Markets Association (AFMA) and Stockbrokers Association of Australia (SAA).

Key issues identified from ASIC’s review were:

• the incidence (or the perception of) conflict of interests potentially arising through research houses’ revenue model, ancillary businesses and analyst arrangements
• the adequacy of skills and experience of research analysts in producing quality research, and
• the lack of transparency and comparability for research methodology.

ASIC also identified an apparent ‘expectations gap’ between financial advisory firms and research houses about the nature and role of research in its review. In particular, advisers expressed a view that research houses should cover less products and undertake more in-depth research. By contrast, some research houses saw their role as providing product coverage for a range of products in each market segment and identifying the ‘best of breed’ products.

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A spokesman for Financial Research Holdings, Mr Mark Carnegie, said, “Lonsec is the leading brand in the investment research sector. This acquisition represents the first part of a growth strategy to build Australia’s pre-eminent financial services research and execution firm.”

Managing Director of Financial Research Holdings, Mr Jason Clarke, expects little change for clients and staff of Lonsec.  “Lonsec has a number of excellent strategies awaiting implementation. So, whilst we hope to enhance services for clients over time, we expect little interruption to the business during the transition period.”

Commented Zurich Life & Investments Australia Chief Executive Mr Colin Morgan, “Zurich’s strategy is to clearly focus on its core business lines to provide financial advisers with innovative, market leading solutions.

“The sale of Lonsec, a non-core asset, reflects Zurich’s focus and adherence to the strategy which has seen our business grow faster than the market over the last two years.”

Mr Morgan added, “Zurich’s considerable investment in its Australian life insurance and investments business in recent years is designed to drive the continued growth of that business.

“Zurich remains firmly committed to being the preferred partner to financial advisers around Australia.”

Lonsec is consistently rated by the financial services industry as the top research and rating organisation, as well as having a specialist stockbroking business aimed, primarily, at financial advisers.

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• 50% reduction in asset sale fees
• Elimination of 2.0% of assets “poison pill” fee

Additionally, Opus Capital was reported as making a commitment  to the investment community through the largest industry research house to halve the $3.0 million acquisition fee proposed in their Opus 21 trust recapitalisation proposal and to waive year one fund management fees in line with the Century proposal. Opus Capital CEO Dean Palmer stated during the meeting that the Opus Capital board will make the reduction in the one off acquisition fee but stated that the research house was in error regarding the waiver of one year’s management fees. Taken together these amendments constitute multi-million dollar fee savings for unitholders.
 
Mr McBain concluded:  “We are very pleased that we stood up for Opus 21 unitholder rights and we are particularly gratified that we have ensured that Opus 21 fee levels have been reduced to market levels on an ongoing basis. Of particular note is the support Century received from major financial advisory groups throughout the country, the advisers we spoke to were very committed to a management change and we are very grateful for their endorsement.”
 
“Century is about to settle a circa $40 million property acquisition in the Brisbane CBD for Century Property Trust 14 – which is already heavily over-subscribed. Additionally, Century has agreed terms on a circa $30 million NSW asset which will form the basis for a further Century property fund.
 
“Century has a very busy asset acquisition programme over the next 12 months and anticipates considerable growth within its $900 million Property Funds Management area.”

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In recognition of Russell Investments’ “strong competitive advantages in people, process and product design” research house Lonsec has awarded Russell’s multi-manager funds a ‘Highly Recommended’ rating.

In its October report, Lonsec reviewed 13 of Russell’s multi-manager funds across both multi-asset and single-asset classes. Lonsec cited the “continued level of sustained stability over the last 24 months” of the Australian investment team and Russell’s “strong performance”, which Lonsec believes “is a reflection of the skill set and resources within Russell working effectively”.

Patricia Curtin, managing director of Retail for Russell, said the ‘Highly Recommended’ rating was recognition of Russell’s continued performance despite tough conditions over the last 12 months.

“Russell’s performance over the last year is a testament to the strength of our stable investment team and our internal capabilities. These strengths mean we are well positioned to capture opportunities for investors now and into the future,” Ms Curtin said. During the past year Russell’s Investment team have added three specialists to its team including Samantha Steele as a senior research analyst, Matt Beardlsey as the Portfolio Manager for the International Shares Fund, and promoted of Scott Bennett to Australian Portfolio Manager.

The report states that “Over all periods assessed, the Russell Balanced Fund has produced absolute returns above the Lonsec Fund Sector Average and benchmark.”

Lonsec said Russell’s strategic asset allocation process was “a prudent approach; that is, ‘get the traditional asset classes right first, and then consider the inclusion of ‘alternatives’.”

Lonsec was also “pleased to see Russell’s recent increased allocation to alternative assets…and the continued research being undertaken to broaden out the alternatives exposure within the funds.”

“Russell has significantly boosted the alternatives team both in Australia and globally this year and we are pleased to meet Lonsec’s approval. We have added new capabilities in alternatives research and strategy which we feel are key strengths of the Russell multi-manager funds,” Ms Curtin said.

Research capabilities – a cut above

Lonsec also mentioned manager research, saying “the breadth and depth of information collected and assessed in its manager research process is a key competitive advantage over peers.”

“We are pleased Russell’s research process has helped us earn this ‘Highly Recommended’ rating. This research capability is present throughout multiple aspects of the Russell business.”

“Part of Russell’s competitive advantage is our on the ground approach to research. We take exhaustive efforts to understand our managers and we’re able to do this as a result of our 30 years experience in multi-managing, global expertise and highly experienced researchers,” Ms Curtin added.

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The first sector reviewed focuses on Market Neutral and will be followed in the near future by CTA / Global Macro, Long / Short Domestic Equities, Long / Short Global Equities, Event Driven, Multi Strategy, Fund of Hedge Funds and Fixed Income.

Commenting on the Market Neutral Sector review, Daniel Liptak said, “Currently significant risk in diversified portfolios arises from equities exposure and this is due to the assumption that over the long run equities outperform. The purpose of the Zenith Market Neutral Sector Report is not to dissect such an assumption, but rather highlight that a significant portion of that equity risk is on the downside.”

“Any investment allocation decision that ignores the consequences of risk and the associated long-term drag on compound returns is deficient. Zenith advocates an investment approach that is designed to minimise this exposure risk.”

The events of 2008 and the subsequent period created an opportunity for the Zenith Hedge Fund Review Team to rationally review the benefits of alternative investments.

“The objections (to hedge fund investments) that were voiced by many commentators regarding liquidity, transparency and leverage are clearly being addressed by the industry,” added Daniel Liptak.

“The negative impact of draw-downs from traditional equities and the affect on long-term compounding is a concern for all investors. Australian market neutral funds have over the last 5 years captured all the upside of the Australian All Ordinaries but importantly did not participate in the downside.”

Zenith’s composite index of approved market neutral funds has delivered a cumulative return of 105%, net of fees, since July 2005.

Over the same period the Australian All Ordinaries Equity Index has returned to investors only 2.24% (gross of fees).

Zenith Investment Partners, Director and Co-founder David Smythe further notes, “Zenith affirms that market neutral funds, when combined with long only equity funds can significantly reduce volatility of the portfolio and simultaneously increase the expected return over the longer term.”

On the issue of fees, David Smythe states that while it is true hedge funds do charge higher fees they are in fact not higher than those charged by benchmark aware managers on the active portion of their portfolios.

There is a compelling argument to suggest that hedge fund managers are charging less for alpha than benchmark aware funds.

“Zenith contends that the focus on fees in the benchmark aware space is therefore warranted – but also notes that any discussion on fees should be undertaken with reference to alpha, not just the headline fee rate,” said David Smythe.

Post review of the Market Neutral sector Zenith’s Approved Listed funds were:

Commenting on the successful establishment of Zenith’s Hedge Fund Review Team David Smythe confirmed that the national research provider is targeting a segment of the research market that currently is not being well serviced.

“There is a “middle market” comprising Private Banks, Family Offices, Self Managed Super Funds and Small Institutions that are demanding specialist consulting services on innovative alternative investments that are not currently being serviced by the large asset consultants or by the research houses.”

“Zenith has therefore sought to extend its coverage, particularly in the Alternatives space for the benefit of not only this target market but also for our existing clients who are interested in more in-depth coverage of Hedge Funds,” concluded David Smythe.

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A Discussion Paper Presented to Minister Bill Shorten

1.1    The objective of this paper is to highlight some issues that exist in the Australian financial services industry that may not get raised by the Institutional and Industry Fund sectors but deserve serious consideration.

1.2    BASIC ASSUMPTION – The Government wants a healthy independently owned sector to maintain balance and choice for consumers with advice and product. The only other option is an industry totally dominated by the Banks, Life Offices [Institutions] and Industry Funds. The independent advice market represents approximately 15% and currently contracting due to Institutional purchasing activity and day to day operational difficulties smaller practice principals are facing. It is common for the smaller groups to sell/join the larger national independent groups who are then selling to the Institutions.

2.1    LOSS LEADING BUSINESS MODELS – The Institutions own or directly influence over 83% of the advisers in the market. The far majority of these institutionally owned practices operate at a significant annual loss whereas the independently owned sector must prove solvency to ASIC to maintain their AFSL. The Institutionally owned practices are permitted to ‘hide’ these annual losses in the balance sheet of their parent company and subside their practices with the embedded profits the Institutions make on the book of business accumulated in their wealth division [from the activity of the practice].

2.2    Essentially, the Institutional practice is a ‘funnel’ for client monies into their wealth division, they are permitted to operate at a loss and the wealth division profits subsidise the advice delivery. The ratio is around 10 to 1 i.e. for every $10 million the institutionally owned practice loses on advice they make $100 million on the embedded profits in the wealth division on the book of business the practice has delivered.

2.3    We have raised this matter with ASIC some time ago, they acknowledged its existence, dismissed it as irrelevant and declared ‘we must cater for all business models’.

2.4     Industry Funds are also operating unprofitable advice practices but are subsidising the practices out of general revenue from other profit centres within their platform business model.

3.1     FOFA REBATE PROPOSAL – The AIOFP agrees that commissions from investment products should be eliminated from the market but however contend that platform rebates/dividends should be treated differently.  A Platform is an administration service that reports to its members, it is not a managed fund or similar. Consumers do not invest into a platform [like they do with a managed fund] they are charged a fee to use the platform to deliver a reporting service back to them. Industry Super Funds are also a platform with similar functionality and service to their members. It could be argued that all Industry Fund members pay for a loss leading advice function that only a fraction use.

3.2    Like Institutions and Industry Funds, Independents want to also use platform profit margins to subsidise advice delivery. Platform profits are a critical revenue source to the survival of the independent sector.

3.3    This begs the most obvious question – why can’t independents operate the same business model as the Institutions and Industry Funds with their white label and private label manufacturing platform models? This strategy allows the independents to use their scale with the Platform providers to get an institutional fee structure that delivers superior pricing to the consumer and a margin/dividend to the independent practice shareholder to subsidise advice delivery.

4.1   TRANSPARENCY IN ADVERTISING – Pre 2005, institutionally owned practices had to clearly demonstrate on all business cards, advertising and paperwork who owned the license they are operating under.  This gave consumers upfront clarity on who they were dealing with and the likely direction of the advice.

4.2    Since 2005 this ‘mysteriously’ changed with Institutionally aligned advisers being allowed to masquerade as an ‘independent’ with no indication on any advertising who they are licensed to. They now only have to divulge their ownership in the FSG during the first client interview. At this point the ownership issue is used as a ‘comfort’ strategy after the adviser’s ‘sales pitch’  and all the clients monies would commonly be channelled in one direction. We raised this issue with Nick Sherry in 2007 who demonstrated genuine surprise the practice had changed.

4.3    Successive Government’s over the years have insisted on transparency as a key     plank in the quest for a professional industry, this is a very fundamental function that has escaped scrutiny.

5.1    INDEPENDENT TRUSTEE/RE ROLE WITH ADMINISTRATION/FUNDS MANAGEMENT – During the 1980/90’s this role was exclusively with the independent trustee sector, the Institutions have now taken control of the functions in house with staff and paid ‘professionals’ on the trustee  committee. Considering the function is largely a supervisory role ensuring that the administrator/custodian/fund manager is adhering to all laws and acting in the best interests of the clients/members, surely this should be performed by an APRA approved third party to avoid conflicts.

5.2    The institutions also treat it as a healthy profit centre charging clients around 12 basis points whereas the cost from the independent trustee sector can be as low as 4 basis points. A change in policy will provide consumers with lower costs and integrity in the process.

6.1    CONFLICTED RESEARCH HOUSE BUSINESS MODELS – Research is the most important function in a practice, it is fruitless to have the best staff, practice, administration and have a flawed approved product list. The practice is therefore an accident waiting to happen.

6.2    The industry largely relies upon Research House ratings to assist their client recommendations. Most advisers do not have the time, expertise or resources to perform the task personally or internally. Over the past 25 years it     has become acceptable in Australia for product manufacturers to pay research houses to rate their products. This profoundly conflicted process has been blamed for a number of second tier product manufacturers ‘buying’ favourable ratings to give them legitimacy with the market. Basis Capital, Westpoint, Great Southern, Timbercorp, Astarra and Willmotts are only a few examples of groups     that purchased a rating and ended in catastrophe.

6.3    If the Government is serious about protecting consumer assets this culture has to be eliminated. Elimination of conflicted research practises will lead to an elimination of “dodgy” product manufacturers from the market.

6.4    Product failure is by the far the greatest cost for consumers with in excess of $6 billion being lost over the past 5 years. The attached article (fig. 1) demonstrates that US Congress has finally dealt with the matter.

6.5     The major issues affecting the research industry are too many operators in the market, insufficient revenue and larger practices negotiating group discounted deals further diluting the revenue pool.

6.6    The Research Houses have become the ‘gate keepers’ in the industry with advisers needing a rating and product manufacturer’s needing inflows. These ingredients have lead to a conflicted dubious environment where inexplicable ratings have been ‘shopped’ around and paid for, leaving clients and advisers the victims.

6.7    Our suggestions are each adviser is levied a fee, the pool is managed by ASIC with 2-4 Research Houses tendering for revenue to deliver advice to advisers and  paying for ratings legislated against. The other option is self regulation by boycotting those who accept conflicted payments. There are only 2 conflict free retail Research Houses in the market, Mercer and McGregor the other 8 accept conflicted payments of varying descriptions.

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What is the role of research houses now? Following the performance of the majority of research houses over the last three to four years – combined with the financial ombudsman ruling last year that now implies financial planners must conduct their own research – a lot of advisers are wondering if they even need to use a research house.

Are research houses now redundant? Or can they change with the times and actually start adding value to the financial advice process?

What value do the major research houses really provide to financial planners anyway? They did little or nothing over the last few years to assist financial planners and their clients to navigate their way through the financial crisis.

The role of a research house should be to scrutinise fund managers and their products, and exclude them if they are sub-standard, and to then let financial planners know the basis of their recommendations. It should not be the aim of research houses to appease fund managers by making it easy for them to get on the recommended list.

Research houses may need to consider to stop taking money (or is that bribes?) from fund managers for ratings so they can be unbiased and transparent in how they develop their recommendations.  Of course, they will then need to increase the fees they charge financial planners.  But this would then result in planners demanding a better service and more accountability from the research houses.  That would be a good result, but I can’t see it happening soon.

Financial planners feel there are a number of anomalies surrounding the output they receive from research houses, including:

• Asset allocation recommendations seem to remain static no matter where markets are placed.  They are the same today as they were during the bull market – shouldn’t there be some adjustment to take into account the value of markets today based on future forecasts?
• What have research houses done to beef up their research capability so that toxic investments are not recommended… or at least are weeded out in a timely fashion?

Most financial planners feel that research houses have not added value to the financial advice process, in fact many of their recommendations put financial planners and their clients in harm’s way.

For example, in 2006 and the first half of 2007 you didn’t need to be Einstein to work out that equity markets and commercial property markets (both listed and unlisted) were generally extremely over-valued.  And yet financial planners had little or no guidance from the research houses, and their asset allocation recommendations to planners didn’t change. This resulted in clients being hit hard when the inevitable correction came.

Further, the so called defensive portfolios contained within some research houses’ model portfolios proved to be not so defensive, with clients taking significant losses on the defensive portion of the portfolio, with no chance of a rebound on lost capital (as is generally the case with blue chip equities following a crash).

Why did this happen?  Was it because those research houses were chasing high returns on high risk fixed interest vehicles such as Basis Capital? I would love to know how some research houses justified shoe-horning  Basis Capital and other high risk investments into the defensive portfolio of their models.

Why chase high returns on the defensive portfolio anyway?  If the client needs higher returns, consider allocating more to growth assets provided they are not overvalued. Defensive assets should be exactly that – defensive.

Over the last 12 months many bond funds have continued to perform poorly due to a combination of interest rate risk and credit risk – and yet they continued to be recommended by research houses.  And still are.  Why be in these funds while interest rates appear to be only going one way – up. Consider that term deposits have proved to be very effective defensive assets over time, with the added advantage that clients know exactly what return to expect from term deposits. I find that there is a certainty about the outcome with term deposits that provides clients with a lot of comfort.

Financial planners and dealers alike recognise they are liable for the advice they provide to clients.  Therefore, if they can’t rely on the support and recommendations provided by research houses, they may as well do it all themselves by developing in-house capabilities.

Surely this option wouldn’t provide a worse result than the one we experienced over the past four or so years when we relied on the research houses?

To be honest, I would still prefer to rely on the research houses… but they need to lift their game first!

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