The truth about the business of research

Despite pay-for-ratings models coming under increasing scrutiny, the major research houses cannot survive on research subscriptions alone. Lucinda Beaman reports.

Business models in the financial services industry have come under increasing scrutiny over the past 18 months, and it is scrutiny the major retail investment research houses have not escaped.

In particular, the practice of fund managers paying research houses for ratings has been questioned in light of some dealer groups’ disappointment with research following the failures of some reasonably well rated products.

Despite some research houses arguing they can quarantine fund manager payments from the research process, the reality is the various remuneration models employed by research houses do have the potential to influence the ratings process (eg, which managers are chosen to be rated), and in a worst-case scenario can influence the ratings issued.

Another reality is that, at this stage, no retail investment ratings house can remain profitable on the revenue received from investment research subscriptions alone.

Many research houses argue advisers and dealer groups are unwilling to fund the full cost of research, leaving them little choice but to fully source or at least supplement their revenue with payments in various forms from fund managers.

Many of the remuneration models employed by Australian retail research houses are hybrids, where both subscribers to the research and managers seeking to be rated pay a fee. That is the case for Lonsec, Standard & Poor’s (S&P) and Zenith Investment Partners.

S&P charges fund managers on a scale influenced by the “nature of the asset class and the complexity of the product”, while subscriber fees are also scaled based on the breadth of research purchased and number of users accessing it.

S&P says the fees paid by fund managers are agreed to prior to the commencement of the research process, with the group saying fund analysts “have no knowledge or influence over the level of fees payable” by managers of the funds they are rating. Fund managers must pay annually for ratings to be maintained.

Zenith also charges advisers and dealer groups an annual subscription fee to access research, in addition to fund manager payments. Zenith, however, conducts its reviews of fund managers prior to charging a fee. Only managers that Zenith adds to its Recommended Product List must pay the research fee.

Zenith director David Wright argues that it is the unwillingness by advisers to pay the true cost of research that drives groups such as his to a pay-for-ratings model.

“If advisers were prepared to pay more for research, we would not need to generate revenue from fund managers. It is important for advisers to understand that the cost of providing research and a research business is not currently sustainable in the Australian market on a subscription basis alone,” Wright says.

“Research groups, including institutional asset consultants, must therefore supplement their revenue in other ways.”

Van Eyk Research employs a ‘user pays’ model, in which advisers and dealer groups pay for research subscriptions and product providers do not pay for ratings, although the group does outsource some of its research to a third party provider (Adviser Edge) that does accept payments for ratings, revenue in which van Eyk shares.

The group says investment research subscriptions and investment consulting account for only 50 per cent of revenue.

The remaining 50 per cent is attributable to investment management of financial services products. Van Eyk Research offers a number of investment management products — a multi-manager unit trust (Blueprint), a managed account service and a listed investment company (van Eyk Three Pillars).

The research house, like many product providers, pays volume bonuses to dealer groups that invest in its funds management products. But van Eyk Research chief executive Mark Thomas says those payments and payments for research are kept separate.

“We can’t bundle — we have a separate contract for research.”

In addition, van Eyk Research takes payments from fund managers for promotional stands and client tables at conferences, although Thomas says there is “no linkage between fund managers paying for a table or a stand and getting a speaker spot”.

“We set the agenda,” Thomas says.

The research house also publishes a magazine twice annually in which fund managers can purchase advertising, but Thomas says advertising is restricted to managers that receive a BB or higher rating.

The research house also offers one paid-for advertorial per edition of the magazine, which consists of a manager profile.

On a pure research basis, Morningstar employs a subscriber-pays model and does not accept payment for ratings.

The group says this, combined with the fact that it does not outsource research to third parties with pay-for-ratings models, allows it to be a “truly independent” provider of research.

But this group would not remain profitable without substantial payments received from fund managers through different business lines, and some of those payments are a precursor to the ratings process.

Funds must be listed on the Morningstar database before they are eligible to be rated, and funds must pay an annual fee to be listed.

Managers cannot pay to be rated by Morningstar. If, however, Morningstar does issue a rating, managers must pay a fee to be able to use that rating in any written material, including information given to dealer groups, or marketing collateral.

The same applies to the marketing of awards granted in Morningstar’s Fund Manager of the Year Awards.

Regardless of whether a fund manager wishes to communicate the rating, advisers and dealer groups that subscribe to Morningstar research will have access to the rating and research report.

Some may perceive Morningstar to be splitting hairs on the issue of fund manager payments. But the research house maintains payments by fund managers for data maintenance and ratings promotions have no impact on the qualitative research process.

Spokesperson Phillip Gray points to the fact that there is “no direct commercial transaction between the fund research business and fund managers”.

“Yes, Morningstar does require managers who wish to keep their fund on our database to pay a data licensing fee every year for the cost of handling the data related to their funds. But that’s a completely separate transaction to anything involving the analyst research,” Gray says.

“I think the fundamental issue is for the production and publication of analyst research and assessment in the form of a rating — there’s no commercial transaction involved.”

Morningstar co-head of fund research Tim Murphy recently used the example of agribusiness managed investment schemes (MISs) in support of the user-pays model.

“We have never issued a research report on agribusiness MISs because we have never seen an agribusiness MIS that has investment merit, and we don’t accept payments from fund managers to rate product,” Murphy said.

“Everyone who has published research reports on agribusiness takes payment for ratings.”

Mercer is in another category altogether, as it is an investment consulting firm rather than a ratings house.

While the group does formulate ratings on funds, it does so not with the intention of issuing them to market, but to underpin its consulting services. Funds issued ratings by Mercer are not allowed to communicate the rating to the broader market.

Mercer is also largely an institutional player, but it does have investment consulting clients in the retail wealth management space.

Research is purchased by institutional and retail wealth management clients via subscription or retainer consulting fees, and Mercer does not accept payments from fund managers in relation to rating products.

Mercer principal Rashmi Mehrotra said the group chooses only to partner with private banking and high net worth-style dealer groups in the retail wealth management space, saying they are the only ones willing to pay the right price for quality research, which in Mercer’s case comes with an institutionally-sized price tag.

“We think high-net-worth clients want institutional quality research and they’re willing to pay for it,” Mehrotra says.

Mehrotra argues the money paid for research by dealer groups is “very little — not enough to sustain the industry”.

“How do you think the research houses will survive? You can’t do the research effectively on your own anyway, so either you increase the price that you’re willing to pay for research and get good research, or don’t complain when research houses then go and charge fund managers to rate them.”