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Interaction between research houses, fund managers, financial planners and
The next three chapters present the evidence from the gatekeepers'
roundtable. It is important in considering this evidence to bear in mind the
different business models within gatekeeper groups, and the potential impact
that those differences can have on the interactions between gatekeeper groups.
As discussed in the previous chapter, these differences include:
- the subscription model and the pay-for-research/ratings models,
and the differences between direct and indirect payments in the research house
the operation of internal research functions by some advisory groups;
- the vertical integration in large parts of the financial services
system where banks and/or fund managers are either affiliated with, or own,
financial planning and financial advisory dealerships.
With these differences in mind, the committee devised diagrams 3.1 and
4.1, representing how the gatekeepers may interact. Gatekeepers' functions are
not necessarily performed by companies operating solely in one part of the
financial services sector. In some instances, all the gatekeeper functions—except
auditing—are performed by different entities within the same corporation. For
example, entities within Macquarie Group offer fund management, RE services,
custody services, trustee services, financial advice and private banking.
Likewise, entities within BT Financial Group offer fund management, RE
services, trustee services, financial planning and private banking. Both
Macquarie Group and BT Financial Group also have an internal research function.
Several of the other gatekeepers also offer multiple services. The auditors are
the exception in this regard, operating independently of the functions of the
other gatekeepers in the system.
This chapter deals with the interactions shown in diagram 3.1 between
research houses, financial planners and financial advisers, and fund managers. A
key focus in this diagram is the business model of the research house.
The first area of committee interest was the relationship between
research houses and financial planners and financial advisers, and between
research houses and fund managers. Several factors led to a focus on the nature
of these interactions.
Firstly, in its report into Trio, the committee had found an expectation
gap around the perceived role of research houses and research reports including
the claims made in a research report and the basis for their formation:
there is a lack of understanding as to the claims made in the
reports issued by research houses and in particular, whether the data provided
by the responsible entity upon which these reports are based has been verified.
There is also some confusion as to whether the ratings are intended as an
indicator of future performance, or simply an assessment of past performance.
Secondly, as noted in chapter 2, the different research houses operate
different business models, with fees and payments to research houses flowing
from the financial planning and advisory sector, and also in some cases, from
the fund managers whose funds are being rated. Given concerns about the
potential impact of conflicts of interest on research quality, the committee
wanted to understand how the different business models worked and how the
conflicts of interest that emerge under those models are either managed or
Thirdly, in November 2011, the Australian Securities and Investments
Commission (ASIC) consulted with the research houses, and in December 2012 it
released a regulatory guide for research houses. The roundtable gave the
committee the opportunity to gain the insight of the research house sector into
the operation of the new guidelines.
Fourthly, following an observation in the 'Bridging the Gap' session at
the ASIC Annual Forum in March 2013 about the influence that research houses exercise
in the system, the committee wanted some perspectives on the impact that a
rating has on the flow of new capital into a recommended fund.
And fifthly, following criticism of research houses during this session,
the committee was keen to question research houses about their accountability
within the financial services system.
What does a rating mean?
The committee report into Trio identified confusion around what a
rating actually means. The committee asked Lonsec Research Pty Ltd (Lonsec) to
clarify the meaning of a rating, the basis for its formation, whether it is an
indicator of future performance, and the nature of quantitative and qualitative
Lonsec told the committee that financial product ratings and research
opinions constitute general advice that is supplied to advice-giving
intermediaries, such as financial planners and financial planners. It noted
that ratings should not be the sole basis of financial advice:
Each of the five research houses in Australia ascribe ratings
to unlisted financial products. The universe of available financial product is
large (approximately 4000 managed funds at the 'headline' or 'parent' level,
and approximately 12,000 funds once tax structures and platforms variants are
accounted for). Each research house identifies a significantly smaller subset
of this universe to submit to their proprietary research processes and the
result is typically a research report (or reports) containing factual
information, opinion, and an overall investment rating.
Each research house has a different basis for, and therefore
definition of, its ratings. This is one of the key points ASIC identified in
RG79 – that users of research needed to be aware of, and understand, the
varying meanings attached to ratings across the research house industry.
Generally speaking though the following statements can be made:
Financial product ratings and accompanying research opinions
are primarily supplied to financial advisers, as opposed to end investors. They
therefore only constitute general advice.
A key part of research house ratings processes is the
categorisation of financial products in order to form peer groups.
Research house ratings are descriptors or labels which
reflect the relative merits of financial products, as determined by each
research house’s disclosed ratings process, and consistent with the stated
ratings definitions. Ratings are typically scale based and therefore relative
to other ratings of like financial products (ie x stars out of 5, A-B-C-D,
Highly Recommended, Recommended, Investment Grade etc). Ratings definitions are
typically displayed within the research report itself, whereas detailed
explanations of research processes are typically made available to users of
research via research house subscriber websites.
Research houses do not typically publish their ratings
without accompanying research. Lonsec believes (and we believe that all
research houses are of the same view) that financial product ratings require
context and guidance (within the bounds of general advice) in order to be used
appropriately. A positive financial product rating can be broadly interpreted
as a professional opinion that a financial product provider has the requisite
investment people and investment processes in place to achieve their stated
product objectives in the future over an appropriate investment time horizon
(naturally, the rating is not a guarantee). A rating (in isolation from its
supporting research) does not tell an investor who the financial product is or
isn’t suitable for, how to use the financial product, how the financial product
should 'behave' in certain market environments, or what key risks should be
considered prior to investing into the financial product. Within the bounds of
general advice, a good research report will provide general guidance and
general opinion to assist financial advisers in forming their professional
views on these aspects. In summary, Lonsec contends that financial product
ratings should form one part of an adviser's overall due diligence process and
should not be used as the sole basis for recommending a financial product.
In Australia, financial product ratings take into account
varying degrees of historical quantitative information (return, risk etc) but
are primarily determined (in a peer reviewed, systematic fashion) by
professional qualitative judgement (subjective opinion). Lonsec understands
that an exception to this general statement is the Morningstar 'Star' rating
system, which we believe to be completely quantitative.
While ratings and research were not intended 'to be a predictor of
future market performance', Lonsec noted that qualitatively determined
financial product ratings were 'intended to be forward-looking':
Research houses will generally have a well defined research
process that outlines the key criteria for determining a financial product rating.
Typically, these processes will have elements of qualitative and quantitative
based analysis. In Lonsec’s case the research process is skewed to qualitative
research as Lonsec believes that qualitative based research is a better
indicator of whether a financial product provider has the requisite people and
processes in place to meet their stated product objectives in the future.
Lonsec believes that while quantitative analysis is useful in assessing a
financial product provider’s historical performance and risk attributes, it is
a poor indicator of a financial product provider’s ability to meet their
objectives in the future.
Lonsec stated that qualitative assessments of investment people and
investment processes accounted for approximately 80 per cent of the rating that
it would give to mainstream asset classes, while quantitative factors such as
emphasis on the returns, risk and consistency of the financial product would
account for 20 per cent of the rating.
Quality and type of investment
research in Australia
The type of qualitative investment research that features strongly in
Australia is more expensive to produce than quantitative research. Lonsec
pointed out that compared to the United States (US), the Australian market is
highly geared towards qualitative research:
the Australian research house sector conducts its managed
funds research in a predominantly qualitative manner. Certain other markets in
the world, most notably the US, are dominated by research houses that operate
primarily quantitative research and ratings processes. Quantitative processes
are mechanised, driven primarily by technology and are scalable. In contrast,
qualitative processes rely far more heavily on people, are therefore more
expensive to operate and are far less scalable unless revenue is directly
linked to research volume.
According to interviews conducted by Mr Jason Spits, a freelance
journalist who contributes to the publication Money Management, overseas-based
fund managers offering investment products into the Australian market are:
often surprised by the depth and rigour local research houses
bring to their work in assessing funds, as well as the necessity of having
products rated before releasing them to the financial planners.
Mr Giles Gunesekara, Head of Third Party Sales at Principal Global
Investors, observes that the quality of research in Australia is higher than
having a tight ratings market has been a contributor to the
level of sophistication of the Australian market, with managers from the UK and
US commenting to us that the research process here is at a higher level than
any other country.
The argument has been made by Mr Tim Murphy, co-Head of Fund Research at
Morningstar that the rigour and independence of the investment research
produced by the research sector in Australia has industry-wide benefits
there were less product blow-ups here than in the US and
Europe during and since the global financial crisis. On that score product
providers, regulators, planners and consumers have been well served by a robust
research house market.
Research houses as gatekeepers
Lonsec explained that elements of the gatekeeper function in the
financial services system have been outsourced to the private sector by the
regulator. Research houses therefore perform a gatekeeper role that includes
assessing products for risks and fitness for purpose:
In contrast to a number of other industries governed by
consumer protection legislation, the wealth management industry in Australia
has historically been lightly regulated. Political acceptance of popular
economic theory currently dictates low intervention in financial markets in the
name of market efficiency; this is not a peculiarly Australian phenomenon.
Consequently, the powers of regulatory authorities (such as ASIC) to act as
broad ranging 'gatekeepers' are relatively limited. Parts of the gatekeeper
function are, by necessity, 'outsourced' from regulators to free market
participants and the regulator's role becomes one of 'holding gatekeepers to
account' for those functions. In more heavily legislated industries, regulators
may undertake a wider range of gatekeeping activities including the assessment
of product 'safety' (risks) and 'efficacy' (fitness for purpose). In the wealth
management industry, this role is performed by research houses.
The role of research houses and
investment research and expectation gaps
Mr Richard Everingham, General Manager of Strategy and Development at
Lonsec, stated that the role of a research house is 'to provide independent
opinion on the quality of investment products in the marketplace'.
He noted that Lonsec achieved this by:
issuing investment product ratings with supporting investment
product research. Lonsec's ratings are determined on the basis of our level of
conviction that the investment products can achieve their objectives and on our
opinion of the relative attractiveness of the products versus their peers.
Mr Everingham differentiated the role of the research house from that of
a financial planner by drawing attention to the general nature of advice
provided by research houses, and contrasting this with the client-specific
advice produced by financial planners and advisers:
Research houses also produce opinion on the nature of
investment products, guidance on how to use them and what features and
attributes they may have which may assist in determining investor suitability.
However, this advice and opinion must by law be general in nature. We do not
know the end investor and, as such, we cannot provide personal advice. This is
the role of a financial adviser.
Lonsec claimed that some financial planners have misplaced expectations about
the nature and use of investment research, and the responsibilities of the
various players in the financial advice chain. In arguing the need for greater
professionalism in some parts of the financial planning and financial advice
sector, Lonsec drew an analogy between the role and responsibility of a medical
practitioner in the health system and the role and responsibility of a
financial planner or financial adviser in the financial services system:
To illustrate this point, Lonsec draws a parallel between the
medical 'advice chain' looking after an individual's 'physical health' and the
financial 'advice chain', looking after an individual's 'financial health' (the
latter expressed in brackets below).
Few would argue that a doctor (advice giving intermediary)
who prescribes an approved (rated) drug (product) to a patient (client) without
first assessing whether a) it is the right drug for the right patient and the
patient’s current circumstances (client suitability and client best interests),
b) understanding what dosage is appropriate and when to take the drug (how to
use the product, including portfolio weighting) and what interactions the drug
may have with others already being taken (overall portfolio impact and
correlations) has failed to discharge their duty of care (common law fiduciary
duty, statutory 'best interests' duty) to their patient. The regulator (ASIC),
the pharmaceutical company (financial product issuer) and independent advice
giving bodies such as the National Prescribing Service - NPS (research houses)
may provide information, education, and guidance which speak to these aspects,
but ultimately the doctor must take this generalised guidance (general advice)
and apply their education, training and experience to each patient's specific
circumstance to make a holistically tailored recommendation (translate the general
advice to 'personal advice').
Despite this clarity in the medical advice chain, a
significant number of participants in the financial advice chain, including
financial planning industry associations, still argue and debate the respective
roles of ASIC, research houses and financial planners. Research houses
encounter misunderstanding, misconception and, in some cases, clear abrogation
of responsibility from a subset of financial planners with respect to what
constitutes investment research, how it should be used, its limitations and the
respective responsibilities of all parties in the advice process.
Specifically, research houses continue to encounter 'expectations
overreach' from a subset of financial planners in the following areas:
- What a rating is and is not and
the degree to which it can be relied upon;
- An expectation that it is the role
of investment research to accurately and consistently predict, thus avoid,
financial product failure;
- An expectation that well rated
financial products will consistently outperform their benchmarks over 'short
- An expectation that well rated
financial products will offer 'downside defensiveness' when markets fall; and
An expectation that all well rated
financial products are suitable for all clients.
Research house business models and
conflicts of interest
Chapter 2 described the various research house revenue models including
subscription fees paid by financial planners and financial advisers
('downstream' payments) and direct and indirect payments from fund managers
A conflict of interest arises in the research function when a fund
manager pays a research house (direct 'upstream' payment) to conduct research
and produce a rating on one of their funds. However, depending on the business
model, there is a range of indirect as well as direct payments that flow
between fund managers and research houses.
In its submission to the Trio inquiry in September 2011, ASIC suggested
that the government might consider banning payments made by fund managers and
product issuers to research houses.
Yet there is no mention of this suggestion in the Regulatory Guide issued by
ASIC in December 2012.
The committee was therefore concerned to understand the suitability and
sustainability of the various business models used by the research houses, and
the adequacy of the arrangements for managing conflicts of interest.
Lonsec argued that the business models operated by the research houses
are a result of the financial planning industry being unable or unwilling to
pay the research house sector for the full cost of producing investment
research. Because of the cost sensitivity of the end-user, Lonsec claimed that
'the entire research house sector provides a materially discounted service to
the financial planning industry'.
As a consequence, Lonsec stated that 'a stand-alone, user pays research
subscription business model is currently economically unviable',
and therefore some combination of payments from the issuers of financial
products or cross-subsidization from other parts of the business is
To ensure a sustainable business model, all research
houses cross subsidise the cost of investment research production through
accepting some combination of payments from financial product issuers, be they
direct or indirect, and/or the operation of one or multiple ancillary business
units (emphasis original).
Lonsec pointed out that most users of investment research require 'high
quality, timely research with sufficient breadth to provide an appropriate
range of financial products for Approved Product Lists'. According to Lonsec,
however, 'these three needs (quality, volume, timeliness) are
operationally conflicting and cannot all be individually optimised'
Given the operational constraints in the research market at present, Lonsec
argued that the costs involved in producing enough high quality research are best
met by direct payments from product issuers:
Conducting sufficient volume of high quality qualitative
research in a timely manner is very resource intensive and therefore very
costly, and inherently difficult to scale up unless revenue is directly linked
to research volume (as it is under a 'pay for research' business model)
Mr Everingham outlined the conflicts of interest that arise from the
choices facing research houses:
Research houses have a choice. They can adopt a model which
is funded, in part at least, by the product issuer. Alternatively, they can
cross-subsidise their research activities from other business units. These
indirect conflicts generally arise through the activities of the other
ancillary business units—not always, but generally. We believe—and we submitted
this to ASIC in the RG79 process—that these types of indirect conflicts are
potentially more problematic, because they are generally not disclosed. They
are generally more multidimensional and they are generally not alerted to the
end investor. The direct conflict in the pay-for-research model, on the other
hand, is apparent and is disclosed. For example, the first line of our
disclosure in our research report mentions that we are paid for the research process
by the product issuer.
Lonsec concluded that:
the interests of all stakeholders - users of investment
research (financial planners), consumers, research houses, Government and ASIC
- are aligned and best served through the existence of a diverse, competitive
and commercially sustainable research house segment.
The implication of this argument is that if ASIC moved to ban the
pay-for-ratings model, the sustainability of a substantial part of the research
sector would be at risk and competition in the research house sector could be
Mr Mark Thomas, Director and Chief Executive Officer of van Eyk Research
Pty Ltd, pointed out that the van Eyk subscriber-based business model
represented the investor and that van Eyk research can only be accessed by those
subscribers that pay for it ('downstream' subscription payments from financial
planners and financial advisers).
Mr Thomas distinguished between indirect payments related to use of the
ratings material and the acceptance of payments to advertise in a research
house magazine or attend a research house conference. He also noted that van
Eyk discloses any indirect payments that it receives:
I do believe that there is indirect and indirect. You need to
look at indirect payments which relate to the process of using the ratings
material. Some houses use a royalty system where they are paid by the issuer
for the use of the rating. We operate a model which does not employ those sorts
of indirect payments. We do have a magazine which has advertising in it. We do
have, in that magazine, advertisements from fund managers who we have rated
well—but who have also been rated well by our competitors. They put those
badges of honour on their advertisements as well. But that is a commercial
decision after the event—after the ratings process.
The indirect side of it—yes, it is disclosed. We run a
magazine. We have a conference. People pay to attend. They may also invite
people to come along as their guest. But that is, again, an arm's-length piece.
Furthermore, Mr Thomas observed that in his consultation with ASIC, the
key criteria that concerned ASIC was not necessarily the research house
business model, but rather the research outcome, and in particular that the
research results were free from bias. Mr Thomas pointed out that the research
results produced by van Eyk illustrated his point:
As it turns out, we recommend less than half of the
investments we review and in our view that is an unbiased outcome.
The contrast between the results generated under the van Eyk model and
those generated under the pay-for-ratings model (that is, paid for by the fund
manager or product issuer) were discussed. Mr Thomas argued that the higher
level of recommendations given under the pay-for-ratings model indicated that
the gatekeeper role of the research houses that used the pay-for-ratings model was
The point I would bring this back to is that it is really
about results and independence around those results. When you look at a
universe of investments, you need to make sure that you are assessing it on
merit. In some cases you will recommend more on merit and in some cases you
will recommend less on merit. But ultimately you need to make a decision and
you need to provide that advice independently to your users. If you are
providing advice and granting a positive recommendation to too many things,
clearly you are not being a gatekeeper—at least not in my mind. We drew
attention in our submissions to ASIC to the unbiased component. As part of
that, we felt that there was clearly a need for higher levels of regulation in
the payment-for-ratings process—because, on the analysis we had seen, there was
a greater level of recommendation occurring there than on the other side, which
is a purely subscription based mechanism where we are just providing advice to
the investor and charging them for that.
We recommended a couple of options there, which ASIC chose
not to take notice of. One was a quota system of higher regulation if that
situation were to occur.
This perspective was disputed by Mr Everingham who argued that because
Lonsec rated less than 20 per cent of the total number of funds in the market
(in other words, it screened out most of the funds), the results would
necessarily include a higher proportion of positive ratings:
I think to complete that information we would like to say
that the spread of ratings under a pay-for-research model is necessarily skewed
to the right of the curve, if you like, because of the number of products that
have been screened out or not rated. For example, Lonsec, which do operate
under this research model, currently rate around 720 headline funds. These
permeate through different tax structures and platforms and so forth, but it is
essentially 720 funds. There are about 4,000 in the universe of the equivalent
total headline funds. So you can see from that that we do not rate the vast a
majority of funds. We have significant screening, significant filtering, and we
would actually contend that the proposition that pay-for-research leads to a
skewing of the ratings that are a positive is actually incorrect.
Perspectives on conducting internal
research versus purchasing external research
There is a trend towards internal or in-house investment research being
conducted by financial advisory businesses. Internal research is typically used
to complement the external research that financial advisory businesses source
from research houses.
Mr Tony Graham, Executive Director and Head of Macquarie Adviser
Services at Macquarie Group, noted that Macquarie Group operated an in-house
research function in partnership with external research houses.
Macquarie Group emphasised that it always sought independent external research
on any managed fund:
In Macquarie's financial advising business, a managed fund
will only be considered for the investment menu if supported by at least one
independent research report e.g. Mercer, Morningstar, van Eyk, Zenith, and
Lonsec. If one doesn't exist and we feel there is a compelling reason to
consider a fund, then we undertake our own in-house research. We may
incorporate a form of research from the manager itself, but not solely rely on
Mr Graham said that Macquarie Group was mindful of the business model
used by the research houses, but that the more important criteria for Macquarie
Group in choosing a research house for a particular piece of work was 'the expertise
of the research manager. We are looking at the next layer down—their track
record and depth of expertise in a particular area to help inform us even more'.
Macquarie Group outlined the criteria that it uses to critically
evaluate a research house report:
Macquarie firstly considers the research house that is
providing the report, e.g.:
- whether the research report is
paid for by fund manager or subscribers;
- the expertise of the research
house in the specific area.
Macquarie’s advisers next consider the report itself and the
level of detail provided on matters such as:
- fund personnel;
- history of the fund;
- performance of the fund under different
- decision making capability;
- experience of staff;
- funds under management (FUM);
- ownership structure;
- fees; and
Macquarie also considers the resources available to the
research house, both personnel and analytical tools.
We acknowledge that many financial advisers may only use one
research house for a view on funds, given the high cost of having multiple
Macquarie Group also outlined the way in which a fund or product was
added to the approved product list:
Macquarie Advisers do not determine the funds or products
which are available on our Investment and Product Menu, they are assessed by
our Unlisted Investment Committee. In order for a fund or product to be
proposed for consideration for inclusion to the menu (in the majority of
cases), an investment grade rating by an external research house is required,
as are other operational criteria. Failing that, or in the event of any change
in rating or other criteria, supplementary research is undertaken by the MPW
Research team and submitted to the Committee.
Mr Royce Brennan, General Manager of Risk at BT Financial Group, said
that from a trustee's perspective, research houses had expertise in different
areas and that an important determinant in selecting a research house was the
degree of expertise that the research house had in the relevant area. He noted
that BT Financial Group had their own research internal research capability
which they used to complement the work of the external research houses.
BT Financial Group explained how their in-house research teams function:
BT Financial Group is supported by two key in-house research
teams, focusing on Advice and Fund Manager Governance.
The Advice in-house research team is responsible for the
review of investments to formulate an Approved Products List which provides
guidance to financial planners when providing advice to customers.
The team undertakes a formal research process to identify
best of breed investment opportunities across all asset classes and product
types. Investments are reviewed and monitored on a regular basis. We note that
the in-house research team is required to assess internally and externally
sourced products in the same way in its research assessment.
The Advice in-house research teams have access to external
research resources including Zenith Investment Partners, Chant West, JP Morgan,
Bloomberg and Morningstar as inputs into the research process.
For the Advice business, external research is also used to
supplement broader investment choice for our external adviser networks.
The Fund Manager Governance in-house research team is
responsible for monitoring and oversight of all investments across our
platform, superannuation and investment businesses.
The team provides analysis and recommendations in relation to
selecting investment options and appointing fund managers, as well as oversight
and monitoring of investment options, for the platforms, superannuation and
As well as undertaking its own due diligence on investment
managers, the team has access to external research resources including Lonsec,
Zenith Investment Partners, Chant West, van Eyk and Morningstar as inputs into
the research process.
One of the key functions of both in-house research teams is
to support the delivery of quality outcomes to clients. We believe an in-house
research function allows greater support that is tailored to the needs of our
financial planning network and allows better oversight of the quality of the
Importantly, BT Financial Group pointed out that they do not offer
incentives to their internal research teams to recommend that any particular
product or asset class be placed on an approved product list.
In explaining its approach to conflicts of interest in the research
sector, Dixon Advisory made the point that external research is just one of
many inputs into its investment advice:
Dixon Advisory understands that most major research houses
receive direct and/or indirect income that creates a perceived or actual
conflict of interest. We prefer to source research from a provider that has
either a clearly articulated business model or adequate disclosures of the
conflicts so that we can assess the severity of the conflict and evaluate the
research with this in mind. More importantly, we try to mitigate the impact
conflicts of interest may have by only using external research as one of the
many sources of information we use when considering an investment. We don't
believe it is appropriate to use external research as the sole decision making
criteria when recommending investments. 
Dixon Advisory performs some investment research in-house and noted that
this is a trend within the advisory sector. It cited better focus and
'transparency over the quality' as an advantage,
but noted that in-house research can increase business costs and that 'it is
not cost effective for a firm of our size to hire a full time research team to
conduct all of the research our advisors and clients require'.
Other factors that Dixon Advisory consider in making a decision about
whether to purchase external research are the asset class or product type in
question and the availability of external research:
In practice this may mean that where we have a significant
focus on an asset class or product type we will look to add capabilities to our
firm so that we can conduct this research in house. For asset classes and
product types that we only see as a small part of a diversified portfolio or
that are extensively well covered by external research we will generally use
However, Dixon Advisory also recognise a dilemma in that the growing
trend to in-house research could damage the business models of the research
houses, which would have negative consequences for the advisory sector:
the research houses need to remain profitable and limiting
their revenue streams could lead to a scarcity of high quality affordable
research – especially on smaller funds. This would be a counterproductive
Dixon Advisory also commented on the claims made by Lonsec that the
research houses provided a 'materially discounted service to the financial
planning industry', noting that:
If there was high quality independent research available in
Australia that not only satisfied compliance requirements but also provided
unique investment thesis, we would be willing to pay an appropriate price for
this research. We have shown this by subscribing to international research on macro
economic views from companies that have a pure independent business model.
Ultimately it is up to research houses to prove to investors
and the financial advising sector that the research that they sell will provide
additional insights not available elsewhere. Until they can justify that the
quality of their research is worth the cost they will not be able to charge the
full cost of production.
Lonsec said that the size of the financial advice licensee typically
influences how they use internal and external research:
Research from research houses is used by financial advisers
in many ways, ranging from being 'hard coded' into the licensee’s compliance
framework to being just one input amongst a number in an overall internal
licensee research effort. An example of the first approach, which Lonsec
typically observes in smaller financial advisory practices, is where a licensee
decrees that the Approved Product List (APL) comprises only Lonsec financial
products rated Recommended or Highly Recommended (Lonsec's two highest
ratings). Such licensees may also decree that the Lonsec's core 'model
portfolios' are adopted as the licensee's 'model portfolios'.
An example at the other end of the spectrum, which Lonsec
typically sees adopted within the largest institutional advice businesses, is
where research house research and ratings are used as a starting point and a
back up to the internal research effort. These licensees typically subscribe to
research from multiple external research houses. The in-house research team
then does 'overlay' and 'gap' research, typically in areas of heightened end
investor demand, heightened risk, heightened financial product complexity, or
areas of perceived weakness in the external provider's capabilities. The
in-house team prescribe their own ratings, select their own APL, and create
their own model portfolios (often in conjunction with consulting input from a
research house). The external research house research and ratings are not 'hard
coded' into the licensee's compliance framework.
The advantages and disadvantages of the two approaches to using external
research were outlined by Lonsec:
The primary advantages of the former approach are cost
savings and advice efficiency – essentially the licensee has outsourced the
bulk of the financial product research process to a third party. A second
advantage is that the size of the APL tends to be relatively large based on
this type of blunt construction criteria and therefore there are fewer
transition issues to consider when new financial advisers join the group (new
financial advisers often bring with them clients who are invested into
financial products that are not on the APL of the new licensee). A third
advantage is APLs will be manufacturer agnostic and independent.
The primary disadvantages of this approach are that the
licensee has not refined the APL or model portfolios to suit their specific
client base and the relatively large APL creates a relatively large compliance
burden (and risk). A secondary disadvantage lies in the aforementioned
over-reliance on ratings relative to other features and benefits of potential
value to clients which may exist in lesser rated financial products. For
example there may be 'Investment Grade' (this is the Lonsec rating below 'Recommended')
financial products excluded from the APL which have better tax efficiency at
certain marginal tax rates or better insurance features (for superannuation
financial products) than the higher rated financial products included on the
APL. Underlying clients of the financial advisers within this licensee will not
have access to these financial products.
The chief advantage of the second approach is greater overall
due diligence and governance, and a more focused APL to meet the needs of the
main end client types or end client scenarios which prevail in that group. A
key disadvantage of this approach is cost – typically only the institutional
licensees and the larger mid tier licensees operate in-house research teams in
excess of 1 person, therefore the capacity to undertake meaningful 'overlay' or
'gap' research is limited. A secondary potential disadvantage is the
possibility of restricted access of non-aligned financial product to the
marketplace. Institutional advisory practices are vertically integrated and,
subject to appropriate internal governance, 'group' or 'aligned' financial
product may in some instances dominate certain sectors within the APL. Given
APLs are often 'capped' in total size (to reduce compliance burden and maximise
oversight and control) this can have the effect of blocking out 'non aligned'
financial product from these APLs within certain sectors.
Lonsec concluded that investors benefit most when there is synergy
between internal and external research teams:
In Lonsec's experience the most effective outcomes for end
investors occur when external and internal research teams work in tandem and
the internal teams leverage the full range of external research services, such
as investment consulting (for APL and model portfolio construction, and
investment committee representation) and the option of direct access to Lonsec's
analysts (to discuss financial products).
Quality of financial advice and
relationships that financial advisers have with research houses and fund
In its 2012 shadow shopping report on the quality of personal retirement
advice provided by financial advisers, ASIC found that:
- 39 per cent of the advice examples were poor;
- 58 per cent of the advice examples were adequate; and
- 3 per cent of the advice examples were good quality.
Lonsec was also critical of the professional standards within segments
of the financial planning industry, arguing that the industry in general made
poor use of investment research, including failing to adequately match products
with client needs:
The first thing I will say is that by necessity that is a
generalised statement. Of course there are many good financial planners. The
issue that the industry has is that there are not enough of them. If you look
at the ASIC shadow-shopping survey, from the last results five per cent or so
were deemed good or better in terms of plans audited. In what we see, the use
of research by the typical or average planner can perhaps be best described as
a compliance tick or something akin to an insurance policy. It is purchased on
price upfront and when something goes wrong the features of what you have
purchased are closely scrutinised.
In terms of the rating, we do our best in our reports to give
guidance on how products should be used. We clearly make it known that a highly
rated product is not suitable for everybody and we see it as the role of the
financial planner to marry the product to the right client—to determine product
suitability. We are making a statement about the outright quality of the
product. The planner must sit in the middle between the product and the
investor and determine whether or not it is the right fit. We take calls and
get feedback. When you have a market downturn as severe as during the GFC you
cop a lot of flack. These are points we make in our paper. They are a summary
of the flack we have copped post GFC.
Mr Graham said it would be 'very risky' for a financial adviser not to
get independent research on a fund and that the common industry practice was to
have independent research to support the advice that would be given to a client
regarding a particular fund.
He noted that the current industry standard is for a financial planner or
financial adviser to work from an approved product list. The approved product
list is constructed based on independent research, which may be internal
research and/or external research from a research house. Typically, an adviser
may prefer to recommend managed funds, or direct equities, or there may be
model portfolio structures from which an adviser may choose.
The model portfolios form the basis of the statement of advice.
However, Mr Everingham was critical of the minimal extent to which the
research produced by research houses ends up in the statement of advice
produced by a financial planner:
The degree to which a research house's research makes it to
the end consumer is dependent upon what the financial adviser decides to pass
through. Our experience from our organisation, given the sorts of hit counts
and so forth we can generate from our website, is that only the most
rudimentary short-form pieces of research are making it into statement of
advice plans that the financial planners approve.
A key determinant of the quality of financial advice is the extent to
which a financial planner or financial adviser understands the needs of their
clients and carefully explain their recommendations. Dixon Advisory emphasised
It is the role of advisers to understand what factors are
important to their clients when making recommendations. Advisers in general can
assist to clearly explain their role and their process for selecting
investments to investors so that the opportunity for expectation gaps to arise
Part of the advice relationship with investors involves identifying the
probability of various risks occurring:
All investors (from institutional through to retail) are
exposed to virtually limitless risk. This means that an important consideration
is the probability of the risk eventuating. While investors need to be aware of
the risks they are facing it is not helpful to highlight all risks equally as
this detracts from the fact that the probability of each risk occurring is
Ultimately, however, Dixon Advisory said that investors must take
responsibility for the risks they are taking on by 'informing themselves using the
information provided to them by advisers and other gatekeepers'.
The Future of Financial Advice (FOFA) reforms place a statutory onus on
financial planners and advisers to put the best interests of their clients
first and to avoid conflicted remuneration. However, in the wake of the scandal
involving the Commonwealth Bank and Commonwealth Financial Planning,
concerns have been aired in the media that when a financial institution creates
financial products and also controls a financial advice network, a situation
could still arise where the commercial interests of the licensee conflicts with
the financial adviser's best interest obligation to their client.
The committee put these concerns to both BT Financial Group and
Macquarie Group. BT Financial Group replied that:
As part of the recent Future of Financial Advice (FOFA) reforms,
which we support, we have implemented new 'best interests' requirements to
further support planners in demonstrating they have met their best interests
obligations to customers.
We have strong and well-established risk management and
governance frameworks. These establish clear protocols for how we operate as a
business, including the products we offer to our customers whether through our
Approved Product Lists or otherwise. We accept that conflicts of interest may
arise from time to time in the normal course of business. However, we are
confident that we have appropriate processes and protocols in place for
managing any such conflicts.
- Our advisers are not restricted to
recommending our products, and they can and do advise on and recommend other
products to our customers.
- We are continually improving our
products to ensure they meet the needs of our customers.
- We have strong controls in place
to ensure that our advisers only recommend products when it is in the best
interests of our customers. Our advisers are required to place customer
interests above their own and above those of the BT Financial Group and the
Westpac Group, and there are consequences for our advisers if they do not do
The committee also questioned BT Financial Group about whether its financial
advisers were subject to sales targets, and any tensions that may exist for its
financial advisers in meeting the best interests of their clients. BT Financial
Group stated that:
We do not employ advisers to sell products. We employ
advisers to provide financial advice and to help meet the financial needs of
We believe in the value of financial advice and we provide
quality advice to customers in a strong and sustainable model.
We do not impose product sales targets on any of our
In the adviser channels we own (i.e. Securitor and BT Select)
we work with financial adviser practices by helping them to attract and service
customers but we do not specify sales or revenue targets for these practices or
their financial advisers.
The salaried adviser channels (e.g. Westpac Financial
Planning and St.George Financial Planning) have revenue targets, and planners
participate in a bonus scheme. All revenue (initial and ongoing), and all asset
categories or products (ie. managed funds, direct equities, etc), are treated
equally under this scheme. Salaried advisers are only eligible to participate
in the bonus scheme if they have met certain requirements within a particular
period (including feedback from customers and meeting compliance requirements).
There are no sales targets relating to particular products, Westpac Group
products or asset classes.
We take our responsibilities seriously in supporting quality
advice to customers. We require planners and management to comply with the law
as well as applicable regulations and company policies. In particular, we
require our planners to comply with best interest obligations and consequences
of failing to comply are serious and can include withholding or cancelling a
planner’s bonus, performance management and, potentially, termination. We carry
out regular auditing of planners. We also assess and review our obligations,
key controls, including our monitoring system, at least annually.
Macquarie Group explained its use of financial advisers as follows:
Macquarie employs Financial Advisers primarily to provide
financial advice and other related services to clients. It is not for the
purpose of selling financial products, whether they are created internally or
Macquarie Advisers do not have sales targets. There are
performance related remuneration criteria in place, however, these apply
equally to Macquarie issued and externally issued products (i.e they do not
incentivise Advisers to recommend Macquarie products, rather than external
Macquarie Group noted that the FOFA legislation may encourage greater
collaboration between financial advisers and product issuers as financial
advisers will now be required to have a better understanding of the financial
products that they recommend to their clients:
FOFA may create an incentive for financial planners and
financial advisers to work more closely with fund managers and product
providers, as they would be keen to ensure that products are developed to meet
the needs of their clients, in terms of features, benefits, services, etc, to
ensure that they satisfy the best interest duty obligations.
Mr Martin Codina, Director of Policy at the Financial Services Council,
noted that in relation to approved product lists and statements of advice, FOFA
will not only impact on financial advisers, but will also oblige licensees to
help their authorised representatives to give advice in the best interest of
the client, and that taken together, this would provide 'quite a robust
The committee also asked ASIC to comment on a situation in which the
financial product manufacturer and issuer also owns a financial advisory
network, leading to a potential conflict between the commercial interest of the
product manufacturer and the financial adviser's best interest obligation to its
clients. ASIC responded:
Section 961J [of the Corporations Act] requires that if a
provider knows, or reasonably ought to know, that there is a conflict between
the interests of the client and the interests of the provider or an associate
or representative, the provider must give priority to the client's interests
when giving advice. This obligation applies to advisers working for an advice
network that is controlled by a financial institution.
Relationships between research
houses and fund managers
As noted earlier, fund managers in Australia regard it as necessary to
have their products rated before releasing them to market. Mr Spits found that
a diversity of views on the relationship between research houses and fund
managers exists, with some fund managers expressing the view that they are
beholden to research houses that act solely in a gatekeeper role, whereas other
fund managers see research houses in a much more collaborative way and view the
financial planner as the ultimate gatekeeper. Fund managers that espouse a
collaborative relationship note that feedback from research houses helps to
increase the quality and sophistication of the financial product. Just as fund
managers have different views on their relationships with research houses, there
is a divergence of views among the research houses on their relationship with
van Eyk told the committee that it was not only financial advisors that
practiced ratings-shopping, but there were also fund managers that would refuse
a review because they feared a negative outcome. Mr Thomas said that research
houses should disclose to ASIC those fund managers that refused to participate
in a review:
There are always going to be people who will shop something
because they are looking for a different outcome. I would argue that it is not
only the advisers who shop the ratings. The fund managers will also shop the
ratings. We have had a number of fund managers refuse reviews from us because
they knew they were not going to get a positive outcome. So they chose not to
participate. That is something which RG 79 covers: we should disclose to ASIC
which fund managers have refused to participate and for what sorts of reasons.
Proposals for an industry body for
the research house sector
Lonsec argued that an essential part of addressing the expectation gap
between research houses and financial planners would be for the research house
sector to form an industry body.
In the wake of the Trio inquiry, Mr Everingham noted that the Financial
Planning Association (FPA) had expressed a hostile stance towards research
houses. He argued that one advantage of a research house industry body would be
the ability to engage constructively with the FPA over points of difference
'and to try and come to some sort of consensus on the way forward'.
Mr Thomas noted that the research houses do have 'informal gatherings where
we have roundtables and discuss things' and that van Eyk 'would be favourable
to regular communication'. However, he questioned whether an industry body was
The different perspectives expressed by Lonsec and van Eyk on the need
for an industry body probably speak to the intense competition in the sector
and the division within the industry over the pay-for-ratings business model
that was identified in chapter 2.
Responses to criticism of research
In the 'Bridging the Gap' session at the ASIC Annual Forum in March 2013,
there were pointed comments about the influence that research houses exercised
in the system, and in particular the impact that a rating has on the flow of
new capital into a recommended fund.
While acknowledging that ratings do influence the flow of funds, Lonsec stated
that this was primarily a function of the 'one size fits all' approach adopted
by many financial planning licensees:
There is no doubt research house ratings have influence on
fund flows but this, in Lonsec’s opinion, is primarily a function of the over
reliance on ratings in isolation from the supporting research. Licensees
ultimately control their APLs and have the responsibility and the authority to
make the final call on what financial products are made available to their
financial advisers to recommend to their clients. Research houses do indeed
perform a filtering, sorting and relative assessment function, as ultimately
expressed through ratings, but the licensee is ultimately the true gatekeeper.
To the degree that licensees choose to determine their APLs through selecting
only the highest rated financial products from a research house, the influence
of research houses is obviously significant. Lonsec would contend however that
this approach has disadvantages and is likely to become less prevalent with
FoFA reforms now enacted.
Another criticism broached during the 'Bridging the Gap' session centred
on an apparent lack of accountability to which research houses were subjected:
that is, there was a feeling that research houses did not have enough 'skin in
the game' because they were not sufficiently accountable to the end-users of their
products when their research was poor.
When this criticism was put to Lonsec, it observed that the research
sector was commercially competitive, and that aggregated ratings performance
was a determining factor in whether a research house would obtain or retain a
Research houses have strong commercial incentives to produce
high quality research and ascribe efficacious financial product ratings. Firstly,
as Australian Financial Services Licence holders, research houses are regulated
by ASIC and are subject to meeting the relevant standards and requirements of
the Corporations Act. If a research house fails to meet any of the required
standards or requirements significant reputational damage would result.
Secondly, research houses operate within a very competitive commercial
environment. The marketplace for research is therefore self regulating.
Research houses are typically engaged on short term contracts and purchasers of
research can and do quickly strip market share from participants that are
perceived to be managing their conflicts poorly or producing compromised or
poor quality research.
On a fund by fund basis, to Lonsec’s knowledge, there are no linkages
between the accuracy of ratings and recommendations and research house
compensation. On an aggregated basis there is however a link. It is a common
practice for research houses to be asked by their clients (or prospective
clients during tenders) for aggregated attribution analysis of the performance
of their ratings and model portfolios. During tenders, research houses are also
asked what their research and ratings history has been with various failed
financial products. The practice is well established and in Lonsec’s experience
the track record of the research house in these aspects typically forms a
material component of the overall decision to retain or hire.
A proposed role for ASIC in closing
the expectations gap between research houses and financial planners
Lonsec made suggestions that ASIC could undertake to help close the
expectation gap between research houses and financial planners. However, they
prefaced this by reiterating their view that the inappropriate use of ratings
by financial planners was the root cause of the problem:
at the heart of the 'expectations gap' is an over-emphasis
and over-reliance on the use of ratings in isolation from supporting research,
and in isolation from fully formed views (at the financial adviser level) about
how a given financial product should be used and who it is and isn't appropriate
for. This can lead to a 'one rating fits all' mentality.
Lonsec also laid out how it saw the role of the research house in
relation to the financial planner:
In Lonsec's view, research houses have a major role to play
in helping financial advisers to reach an understanding of the nature of
financial products, a moderate role with respect to understanding the
appropriate use of financial products and a minor role with respect to
identifying investor types and investor scenarios best suited to financial
While acknowledging that the FOFA reforms and the guidance in RG 175
would improve the quality of financial advice and help close the expectations
gap significantly, Lonsec outlined proposals for ASIC intervention:
ASIC could provide the marketplace with a statement as to
what financial product ratings are (and aren’t) and what they can (and can’t)
be relied upon for (by users of research). In particular, Lonsec believes an
expectations gap will remain as long ASIC remains silent on the expectations from
some users of research: that
a) it is the role of research to accurately and consistently
identify fraudulent conduct which may lead to financial product failure, and
b) that research houses should be able to accurately and
consistently predict extraordinary market events which may cause market and in
turn financial product failure.
ASIC could provide specific and granular guidance that before
recommending a financial product it is the ultimate responsibility of the
financial adviser, not the research house, to understand the following:
The nature of the financial product
How complex is the financial product? What assets or other
investments does the manager of the financial product invest into? What drives
the performance of those investments? What are the key risks of the financial
product which pertain to the probability of: a) loss of capital, b) loss of
income, and c) loss of access to the investment (liquidity)? What are the
objectives of the financial product? What is the likely performance of the financial
product under common market scenarios? How tax efficient is the financial
product at various marginal tax rates? Where the financial product’s objective
is stated as a targeted return, what is the likely split of return between
capital growth and income? How, at all, does the financial product take into
account environmental, social, or governance factors? What other features and
benefits accompany the investment (eg insurance within a superannuation fund,
platform implementation, administration and reporting features and benefits
where the fund is accessed via a platform). What are the costs of investing
into the financial product and accessing any additional features and benefits?
The investor types or investor scenarios best suited to
the financial product
Based on the nature of the financial product and the
financial adviser’s knowledge of individual client needs, goals, objectives,
tolerances, preferences and financial literacy, which clients are suitable for
the financial product?
The appropriate use of the financial product
For those clients deemed suitable, how does the financial
product fit within an overall portfolio? What should be the maximum portfolio
exposure limits (%) to the financial product? How is the financial product
likely to interact with other investments within the portfolio (correlations)?
What is the minimum time frame for investing into the financial product? What
is the appropriate time frame to review the performance and efficacy of the
Lonsec's criticisms do not apply to all financial advisory firms. As
noted earlier, Dixon Advisory told the committee that a professional advisor
must analyse a range of information from a variety of sources and that external
research was only one input into informed investment advice.
This chapter has focussed on the role of research houses in the
Australian financial system and in particular, their links to the upstream
market (fund managers and product designers) and the downstream market (financial
advisers and planners). It has noted that while ASIC has identified some
measures to improve the quality of investment research in Regulatory Guide 79,
there remain some fundamental systemic questions about the role of research
houses, the utility of their products and the way they are remunerated.
The committee received some evidence that financial planners and
financial advisers have not used research house reports to the extent that
research houses would want. This may partly reflect the fact that financial
planning firms have increasingly conducted their own in-house research; but it
may also suggest that the type of general product research that research houses
provide is simply not valued by financial advisers.
The committee believes that research houses' 'downstream' interactions
with financial planners are particularly important. This is the 'user pays'
business model. The utility of research houses, the quality of their research
and the extent to which they should be held accountable for their output must
all be linked to the end-users of their products—the clients of financial
advisers and financial planners.
ASIC has told the committee that in using research house services, the
financial adviser or planner will need to consider the business model of the research
house, potential conflicts of interest because of the associations of the
research house, how the research house selects products for rating, the
methodology the research house employs and its spread of ratings. Even with
this due diligence, it will be interesting to see whether the FOFA changes—with
the best interest duty enshrined—will change financial advisers' and planners'
uptake of research house products. It may be that financial planners need to do
more of their own research.
In this context, the upstream linkages between research houses and fund
managers are of concern. This is the 'issuer pays' business model. The
committee believes that research houses should carefully manage their pecuniary
arrangements with fund managers, whether direct or indirect. To the extent that
these arrangements exist, they should be disclosed to ASIC and to financial
advisers that use the research. The committee also supports ASIC's position
that robust controls should be in place to ensure fee and contractual
arrangements, relationship management and/or ancillary business units are kept
separate from the ratings process and outcome.
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