The current financial crisis and invest ment market “meltdown” has shone the spotlight on virtually all participants in the financial services industry in an effort to identify what went wrong. What started as a focus on invest ment banks, credit rating agencies and mortgage brokers in the US quickly spread to banks, financial advisers, fund managers, other investment product providers, governments and industry regulators worldwide.
More recently this “net” has also included re search houses, with Senator Nick Sherry, minister for superannuation and corporate law, stating that there will be greater focus and a tougher compli ance regime for rating agencies and research houses. Included in this statement was a requirement for research houses to be licensed with the Australian Securities and Investments Commission (ASIC) via an Australian Financial Services Licence (AFSL). This is an interesting statement given that research houses are already required to hold an AFSL in order to provide research and general investment ratings to financial advisers. This is unfortunate as it has created some uncertainty and a lack of confidence in the current regulation of research houses at a time when consumers are seek ing assurances and confidence in how our financial institutions operate and are regulated.
To be fair, the catalyst for the Government’s review and comments have been the activities of the credit rating agencies and their roles in provid ing investment structure advice and then rating the structured credit securities that have been at the heart of much of the US sub-prime mortgage problems. While these rating agencies are global organisations, there has not previously been a re quirement that their Australian arms operate under an AFSL.
This issue has brought into focus the potential conflicts of interest of a rating agency being paid by the organisation seeking the rating. The Govern ment has rightly expanded the review to include research houses, many of which (Zenith included) also charge the fund manager or investment prod uct provider for the research and rating.
THE COST OF PROVIDING RESEARCH
The breadth of product coverage and the depth of research due diligence is a direct function of the number and quality of research personnel. In order to employ experienced and high-quality investment analysts, research houses compete with the rest of the financial services industry from a remuneration perspective. In the highly paid financial services industry, the actual cost of providing research is significant. As with any business, these costs need to be covered for the business to remain viable. Industry evidence suggests that the cost of providing research is either subsidised by charging fund managers or product providers for ratings, or operating a funds management business (imple mented consulting), or both. There are very few, if any, examples of research organisations that sustain themselves on user research subscriptions alone.
AN ALTERNATIVE MODEL: USER PAYS
To the layperson, the solution to this potential conflict of interest appears obvious; that is, operate a user pays system where the user of the research and rating pays for the service. While in theory this approach provides a cleaner, independent ap proach, in practice the cost of providing this service would ultimately be borne by the consumer, being the investor. To understand the mechanics of this fully, the direct users of research house ratings and research are financial advisers who use the informa tion to assist in advising their clients, constructing portfolios and in meeting their compliance and professional indemnity insurance obligations. In a user pays system, it would therefore be the financial adviser that pays for the services provided by their research provider.
While this already occurs, with research houses generally charging an annual subscription for provision of research and ratings, the cost of providing this service is effectively heav ily subsidised by fund managers paying research houses to rate their product. In a pure user pays system, fund managers would no longer pay for ratings and the full cost of providing research and investment ratings would be borne by the financial adviser. The likely outcome of this system is that the financial adviser would pass the cost of research on to their clients, thereby increasing the cost of financial advice to the client. This is a significant is sue as already the cost of financial advice is beyond many consumers, particularly those with small amounts to invest.
FEES AND CHARGES
Keeping the costs of financial advice at the same or similar levels under a user pays model requires a redistribution of the fees and costs of the services provided. These include the fee for advice charged by the financial adviser (may be fixed amount or percentage based), the cost of the administration platform (percentage based), the product man agement fee (percentage based) and the cost of research (usually fixed dollar fee). Under a “pure” user pays model, where the financial adviser pays for the research and passes the cost onto the client, there is a redistribution of the cost of research from the fund manager/product provider to the financial adviser.
As a result, an alternative approach, and one that is unlikely to be popular with fund managers and investment product providers, is a reduction in the management fee of funds/products. On face value, this appears to make sense, as fund manag ers and/or investment product providers would no longer incur the costs of paying for ratings and their profit margin would increase as a result. The obvi ous problem with this model is that research fees to advisers are generally a flat fee while fund and product management fees are percentage-based, thereby making it difficult to arrive at a generic management fee reduction that compensates inves tors with different amounts to invest for the cost of research. If the cost of research was charged on a percentage basis and therefore variable, based on the amount the client has to invest, this would be more achievable but raises the issue of who would administer this fee.
Unlike an investment product, where the manager simply applies their percentage manage ment fee against the amount invested, a research house would rely on a third party to administer a percentage-based fee as they are not in control of the money invested. The most logical administra tor of this fee is the financial adviser’s administra tion platform provider, but not all advisers use an administration platform. In addition, a research group’s revenue would become a function of the size of their adviser client base and the size of funds under advice of these advisers. Perhaps it’s not such a “pure” model after all. Clearly, a change from the common research remuneration structure is a dif ficult one.
NO CONFLICT, NO INTEREST?
The old Silicon Valley adage of “no conflict, no interest” appears relevant to the financial services industry. Perhaps it’s time for the industry to acknowledge that there are potential conflicts of interest throughout the industry and that these conflicts are often necessary remuneration struc tures to ensure the financial viability of industry participants in order to provide a service. This is not just an issue for research houses but for many participants in the financial services industry. Potential conflicts of interest exist for financial ad visers via the payment of trail commissions by fund managers, fee rebates from administration platform providers; for administration platform provid ers via rebates/reduced management fees from fund managers; for fund managers via reduced brokerage/other services from stockbrokers, and for industry funds via the support of investments undertaken by member organisations.
Unless these potential conflicts can be fully eradicated; which would require significant industry restructure, the real issue is ensuring that any potential conflicts of interest are fully disclosed to the client and do not compromise the quality of investment advice. As such, the most likely approach of the regulators is to ensure research houses effectively manage and disclose potential conflicts of interest as should all industry participants.
While the result of the Government’s review may be to impose further formal reporting and/or compliance requirements upon research houses, already it is in the interests of research houses to effectively manage potential conflicts of interest as a result of the very nature of their business activities. That is, any research house that wants to remain in business and minimise litigation risk must ensure their research and ratings are soundly based and backed by detailed due diligence and rationale. Those who do not provide a quality service and rat ings will not be in business very long. This is a fact, irrespective of who pays for the research.
