Ratings houses – objective assessors or players?

Mike Taylor writes that in an environment where intermediaries clip the ticket for around 40% of the cost of investment, the provision of research and ratings is becoming a vehicle for the pursuit of multi-faceted business strategies.

The level of recent private equity investment in Australia’s funds management research and ratings houses directly reflects how influential they really are for both fund managers and, ultimately, financial advisers and their clients.

Private equity investors tend to zero-in on targets they perceive as having prospects for growth and market expansion, and the recent Australian Securities and Investments Commission (ASIC) Report 702 makes clear just how core research and ratings houses have become to the dynamically-evolving Australian funds management landscape.

Over the past half-decade private equity investors have controlled two of Australia’s most significant research and ratings houses – Lonsec and Zenith – with Zenith only late last year being acquired by UK/European funds management data aggregator, FEfundinfo, which is in turn owned by European private equity player, HG Private Equity.

Also worth noting is that the ratings house market has undergone its own form of consolidation with Lonsec being joined together with SuperRatings as part of the initial private equity play led by Mark Carnegie while Zenith was joined with the other significant superannuation funds ratings house Chant West. The result is that both companies are now rating both managed investment funds and superannuation funds.

As well, while Morningstar provides quantitative funds data to SQM and a number of the investment platforms, FEfundinfo provides quantitative data to Lonsec, Mercer and its newly-acquired Zenith.

Morningstar and FEfundinfo also have publishing arms with Morningstar owning FirstLinks (formerly Cuffe Links) plus its Morningstar.copm.au web site while FEfundinfo owns Money Management and Super Review.

Australia has five ratings houses working into the retail investment space – Morningstar, Lonsec, Zenith, SQM Research and Mercer. Of those, only two could be described as wholly Australian-owned – Lonsec and SQM Research.

What financial advisers should also know is that in an Australian market made up of those five significant research and ratings houses, the underlying quantitative data is delivered from just two sources both of which have skin in the qualitative ratings game – the Chicago-based Morningstar and the UK/European-based FEfundinfo.

Also worth reflecting upon is that with the exception of SQM Research each of the research and ratings houses who have become fundamental to the make-up of the Approved Product Lists (APLs) of financial planning groups also have skin in the game with respect to investment products, particularly managed accounts.

While the activities of research and ratings houses have never been subjected to the level of scrutiny imposed on financial advisers, ASIC made clear via its Report 702 substantially compiled by major consultancy, Deloitte, that it does see problems with respect to the commercial models being deployed by the ratings houses.

Report 702 referred to the dynamics of “supply side” and “demand-side” business models and the issues they created.

Representatives of the major research houses interviewed by Financial Newswire defended their commercial models and their overall objectivity but, hardly surprisingly, those on the supply side were less than complementary about those on the demand side.

SQM Research founder, Louis Christopher makes no apology for the fact that his firm runs a “supply-side” model and charges for ratings and says that notwithstanding the rhetoric and the methodology, those on the demand side are also being paid for ratings.

“Who are they kidding? Who is falling for that? Everyone knows that they charge,” he said.

“We charge for a rating, we do not run consulting, we do not run models and we have no intention to do consulting or run models,” Christopher said. “We do sit on investment committees to help with APL selection but the consulting will not go beyond that at all and, of course, we do not run products.”

Christopher said SQM’s conflict was that it charged for a rating but that it sought to minimise that conflict by charging a flat fee widely known in the industry which was consistent across classes and did not change irrespective of whether a client was a large or small manager.

“We charge the fee upfront before we start the process and the client needs to pay the fee upfront before we get into the rating and I like to look at it as being like an auditing cost,” he said noting that SQM’s own auditor was scrupulous in dealings with the firm and that SQM sought to be similarly scrupulous in its dealing with fund manager clients.

“Given that we are rating 350 managers from a very diverse group we are definitely not held to ransom by any one individual manager,” Christopher said.

“So, in an ideal world there would be a situation where managers do not pay fees and it’s all done by advisers similar to the old Van Eyk model but, sadly, even Van Eyk couldn’t hold that model together. They went down the path of running funds.”

“Sooner or later, someone has got to pay for the cost of these things and, in the end, the adviser can only pay so much because as we all know many advisers out there are doing it relatively tough and don’t have a lot of money to spend and ultimately the consumer, the end-investor, is not willing to spend that much money on advice services,” Christopher said.

“Everyone wants great information, but few are willing to pay for it,” he said.

“So, we do a rating like an audit. Auditors charge and some naughty auditors have consulting on the side and that is where they also get themselves into trouble,” Christopher said. “Our revenue diversifier is data and that data is property data but its also fund data and its soon going to be equities data and in the first quarter we’re going to release a product where we’re doing ratings on direct equities.”

Scale and global reach makes Morningstar a very different proposition to SQM, but the company’s Australian director of Research Ratings, Annika Bradley sees the company’s model of not taking payments from fund managers as being critical to its independence.

“Given our model and clearly Morningstar is committed to the principle of independence we don’t accept payment to produce qualitative ratings and I think that does position us in the market slightly differently from an adviser’s perspective,” she said.

“There is no doubt that the industry has changed and with the considerable level of fragmentation that has occurred in the advice space, I think research and ratings houses are probably more important than ever in terms of supporting advisers and particularly small advice practices and independent financial advisers.”

“I think the landscape has changed and that Morningstar is well-positioned from an independence perspective to provide quality research and quality ratings to advisers but we always have that tension of having a huge level of coverage because we are basically guided by client demand compared to what we can produce from a resourcing perspective,” Bradley said. “In the absence of the pay to play model we’ve got a few other trade-offs compared to a few other houses.”

Asked about the fact that Morningstar has products in the market, Bradley acknowledged the firm was in the consulting business but sought to stress that this did not distract her team in terms of generating independent ratings.

“From a ratings perspective we are cognisant of our Morningstar Direct users, our adviser research centre users and the traffic we are getting through Morningstar.com.au to help us determine our coverage universe,” she said.

Lonsec director of Sales and Marketing, Rob Hardy, while acknowledging the firm’s consulting and managed accounts activity, insists that the company is not wanting to become a product manufacturer.

Referencing an address to staff by the company’s chief executive, Mike Wright, he said that with respect to the growth of Lonsec going forward Wright had been very clear in stating that it would not be a product manufacturer.

“He [Wright] said Lonsec does not seek to be a product manufacturer – we are not looking to go into competition with our fund manager clients,” he said.

“We have portfolio construction expertise and we’ve producing model portfolios which aren’t implemented for many, many years and we’ve presented them in an implemented format, which is the managed accounts format, and that’s a part of the business that we’re absolutely seeking to continue to grow.”

“Our inflows have been well in excess of $100 million a month for quite some time now and they continue to increase month on month and we’ve got wide coverage across most of the major platforms now and we will continue to look to deliver the best outcomes for advisers because we think managed accounts are a good solution for them given the compliance and regulatory burdens that they have.”

ASIC’s Report 702 makes a pragmatic assessment of both the commercial models being utilised by the research and ratings houses but its analysis raises particular issues with the supply side regime.

“The supply-side business model employed by some research houses represents a potential conflict of interest, as they are remunerated by the fund managers they are rating. This creates incentives to give positive ratings (and not give negative ratings), and it is not required that research houses publish negative ratings as well as positive ratings,” the report said.

“The business model also allows fund managers to search for the research house that will provide them with the best rating, then pay for this rating and use it in their advertising material.”

“ASIC regulates this conflict by requiring research houses to disclose any benefits they receive from the report in their reports or advertisements. However, multiple fund expressed concerns with this business model, for example where research houses are only paid for providing a certain rating, indicating that disclosure of conflicts may be insufficient to prevent this misuse of market power.”

“Evidence also indicates that the supply-side model is significantly more likely to generate positive ratings than the demand-side model.”

Interestingly the ASIC Report 702 does not extensively delve into the consultancy businesses run by the ratings houses or explore how, while underwriting the ratings business, this may be perceived as compromising their work.