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Research Houses: Payments skew reliability of investment advice

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Conflicts of interest over fees and charges lie at the heart of an ASIC inquiry, writes Ruth Williams.

Date May 1, 2012

 They are a crucial links in the chain of financial advice by wielding enormous influence over the products that retail investors sink their money into. Now research houses face a huge regulatory shake-up.

After a string of collapses of retail investor-targeted companies that were rated highly by research houses - including Timbercorp, Westpoint, Basis Capital and Trio Capital - the Australian Securities and Investments Commission is pushing to make the sector more transparent and accountable.   (Ed:  Really?  Like pushing a pram with a gentle nudge that takes seven years?)

It is a move that has been welcomed by most people in the research industry. However, it comes as one player, Standard & Poor's, is preparing to close its funds research operation, and as some of its rivals warn that a poorly thought-out crackdown could force out more operators, potentially reducing competition and raising costs for financial planners and their clients.

As ASIC is discovering, the research house sector has a range of real and potential conflicts of interests, with myriad payments passing between issuers - the fund managers who make and sell investment products - and the research firms that review and rate them for the eventual benefit of investors. How well those conflicts are disclosed and managed is a matter of debate inside and outside the industry. With each research house insisting on its own purity - and several happy to question that of their rivals - ASIC is unravelling the various payments and arrangements that crisscross the industry.

It is not just the most overt and talked-about conflict in the sector - when fund managers pay research firms to rate their products - that has ASIC concerned: two of Australia's five remaining research houses accept such fees, which ASIC has asked the government to consider banning.

There is also a plethora of other payments from fund managers to research houses: licence fees to use logos and ratings on promotional products; sponsorships for conferences; advertisements for magazines and database fees among them.

Then there are the research houses that operate their own fund-management arms, seeking business in competition with those they rate.

''There are a range of different streams and flows of money around this industry,'' an ASIC spokesman told BusinessDay. ''We were aware of a number of them but more have come to light.''

Research houses are highly influential: financial planners pay close attention to their research and ratings, which help them decide which products to recommend to clients.

But the failures of Basis Capital and its ilk have drawn attention, in ASIC's words, to whether research houses are ''managing their conflicts adequately, and otherwise providing high quality, appropriate and compliant services''.

The three research houses that do not accept payments from fund managers for research - Morningstar, Van Eyk and Mercer - argue that their business model is inherently superior and less conflicted, and that the regulator's attention should be focused on those who do charge for research."

There are conflicts in any business that you have, but we think those conflicts are heightened in a [issuer] paid model," says Morningstar Australia's chief executive, Anthony Serhan. "It just brings into the space a lot of influences that don't arise in a subscriber-paid model."Stephen Roberts, the head of investment management for Mercer Asia Pacific, says that by not accepting such fees the firm can be ''completely at arm's length'' in rating a product. Firms that charge for ratings are simply in a different ''head space'', says Van Eyk's chief executive, Mark Thomas.

''The most important conflict that one needs to manage in this process is, who do you represent, and who is your customer? In our case, we always represent the investor. We are aligned with the adviser and the adviser's clients.''

Lonsec and Zenith Investment Partners, research houses that do accept fund managers' payments for ratings and are thus most in the regulator's sights, say they manage this conflict ''stringently''. The threat of litigation for poor research, and the lack of clients that would result, are powerful motivations, a Zenith director, David Wright, says.

''The market self-regulates,'' says Lonsec's manager of research strategy, Richard Everingham. ''We would be out of business if we didn't manage our conflicts well.''

Lonsec and Zenith warn that a mishandled regulatory crackdown could reduce the availability of research, to the detriment of investors. A subscriber-based model passes the ''man on the street test'', Everingham says: ''It is intellectually and intuitively correct and it lacks apparent conflicts.''

He says the problem is that a standalone subscription model would not be profitable because those who use the research - financial planners - will not pay the full cost of its production.''

It's the reality we all deal with,'' he says. ''All research houses respond by cross-subsidising research costs with revenue generated either directly, or indirectly, from fund managers, as well as through other activities like running funds management or data collection arms.''

Indeed, Zenith's Wright asks if the most obvious potential conflict is the most problematic. "Wherever there is a payment there's potential for a conflict; no doubt. But I think it's whether that is disclosed and it is the way in which it is managed.''

At the moment there is not a level playing field on the disclosure of other manager or product provider payments."There is a long list of these ''other payments'', and how serious each of them is is a matter of contention within the industry. ASIC is still making up its mind."As people have debated this one a little more over the last few months there have been more coming to the surface, which is the valuable part of having a consultation process,'' the ASIC spokesman said.''We are interested in all of them. We don't have a set hierarchy of severity at this stage."Such payments include licence fees that Morningstar charges fund managers for using its logo and ratings on promotional materials. There are conference sponsorships and magazine advertisements. Van Eyk runs fund managers' ads in its twice-yearly magazine; Morningstar owns the widely read Investor Daily online newsletter, which carries prominent ads for Zurich and Fidelity.


This year's Morningstar investment conference is sponsored by fund managers, including Zurich and Dexia. Van Eyk holds an annual conference and Mercer hosts forums that fund managers pay to attend.''

The managers get to spend time with us and spend time with our clients en masse,'' Mercer's Roberts says. ''The content is completely independent of anything to do with who might be attending.''

Morningstar also runs an industry database for which funds must pay to be listed in, and it rates only the funds listed on this database. Morningstar's Serhan says this is because ''most of the stuff being sold into the retail market is on our database''.

He rejects the argument that the various payments Morningstar takes from fund managers pose a potential conflict for its research operation. Each part of the business - the conference arm, the database, Investor Daily - operates independently and must stand ''on its own two feet'', he says.

Charging licence fees to use its logo and ratings ''allows us to control how our intellectual property is being used and being used in a proper fashion,'' Serhan says, adding that the licensing deal is struck after a fund's rating is finalised, by a group that works separately from the analysts who rate the funds.Van Eyk, which trumpets the fact that it does not accept fees from product issuers, has a partnership with the property and agribusiness researcher house Adviser Edge, which does. Van Eyk's analysts vet Adviser Edge's research, Thomas says.

The firms that do not charge for their research insist that their other operations do not ''subsidise'' the research, as Lonsec suggests. In fact, Van Eyk's research business is a ''cash cow'', Thomas says.

One big question is what would happen if fund managers' payments for research were banned, as ASIC has recommended. Lonsec's Everingham warns of unintended consequences. ''It's a case of be careful what you wish for,'' he says. ''Such payments underpin the research produced for more than 50 per cent of the financial planning market.''If these payments are banned, we believe effective research house competition and research provider choice could diminish; availability of research reports could be reduced, and almost certainly research costs to financial planners would increase,'' Everingham warns.''ASIC's aim of wanting retail investors to be better educated, better informed and making better investment decisions won't benefit from an outcome like that.''


Submissions to ASIC's consultation paper were due in February. ASIC had hoped to draft a new regulatory guide by April, and finish it by May. BusinessDay understands this deadline is likely to be extended, partly because of a delay in the report of a parliamentary inquiry into the collapse of Trio Capital that is examining the role of ''gatekeepers'', including research houses.

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 EDITOR:  So how does ASIC explain that it found the problem years ago and are by confession looking at the issue NOW?

What wallies!  Westpoint went down 7 years ago and same as all others mentioned...........yes and the rating houses have been heavily criticised in the past by ASIC.....they recycle reports.....yet they have done nothing to PROTECT CONSUMERS by doing something about it and locking up a few white collar criminals....on the higher levels.


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