How independent is the managed funds research that we rely on? John Collett investigates.

The researchers are the gatekeepers who decide who gets to manage a large chunk of our savings. Financial planners will not look at a fund manager unless it has at least an investment grade rating from a research house.

But how far can managed funds researchers be trusted to act independently - to make ratings decisions regardless of commercial considerations?

From January 1, new rules mean those holding Australian financial services licenses, including funds researchers, will need to be more vigilant about managing their conflicts of interest. Even so, the pressures to compromise research are probably increasing. That's because researchers struggling to turn a profit from research alone are branching out into more profitable activities, such as funds management and consulting. Even more fundamentally, the way the researchers get paid also casts a cloud over their independence.

As a result of these conflicts of interests, bad funds rarely get rated, which means they are not being flagged to the public. There can be a lot of noise when funds are highly rated, but when they are failing there can be silence from the researchers. That goes to the heart of the question - can the output of the research houses really be called "research" when the results are heavily skewed towards positive results?

The issue was unintentionally reopened by ASSIRT Research last week, when it announced measures to help it deal with conflicts of interest that, critics say, are inherent in its business model.

Fund managers pay ASSIRT to be rated. That means no funds manager is going to pay for research if it believes its going to be rated as a "non-investment" grade fund manager.

For the fund managers, the ratings game is about getting an "investment grade", at the least, so their sales people can talk to financial planners who cannot otherwise recommend funds to their clients.
ASSIRT insists that its ratings are not - and have never been - for sale.

The changes, it says, are simply to ensure continued faith in the independence of its research.

First, ASSIRT will no longer disclose its ratings to managers before publishing. A draft of the research will still be given to the fund manager for fact checking, but not the rating that has been assigned.

Second, ASSIRT will require fund managers to charge full ratings fees at the outset of the ratings process. It takes an initial fee before the ratings process starts and a second payment down the track.

ASSIRT says charging full fees before starting research on a fund manager will avoid any possibility of undue pressure on the rating by withholding payment.

"The new policy ... aims to ensure that public perception of ASSIRT Research's integrity is appropriately matched to the highly unbiased nature of its research output," it says.

While Assirt defends its model, in the United States The Washington Post has criticised the "pay-for-ratings" system.

The newspaper alleges companies that refused to pay for the ratings were downgraded or had their ratings withdrawn by Moody's and, to a far lesser extent, Standard & Poor's. They are only allegations, and no one is saying that ASSIRT follows a similar business model, but it's likely that the "pay-for-rating" model is about to receive further attention from US regulators.

ASSIRT is owned by St George, which also owns the Securitor and Pact financial advisory businesses and the Asgard investment platform. Fund managers generally seek an investment grade rating from ASSIRT to get onto the Asgard platform and the approved lists of the St George-owned planning firms.

ASSIRT's two main rivals do not charge managers to be rated. Nevertheless, they are not free from conflicts of interests, either.

Morningstar receives "royalty" payments from fund managers when the ratings are used by the fund manager in its marketing and advertising campaigns. The potential chink in this business model is that Morningstar may be tempted to put most of its efforts into rating big fund managers (with big marketing budgets) that are likely to be rated favourably.
Of the 1082 funds on the ASSIRT database as at November 1, only 10 (less than 1 per cent) had a "sell" recommendation. Like ASSIRT, Morningstar has a bias to "quality" managed funds.

"I do not believe that you can get fully independent research," says financial planner Kevin Bailey of the Money Managers. "They do tend to favour the big institutions with the big pockets rather than [the] smaller players that may be appropriate for investors."

Another potential problem with the Morningstar business model is that the researcher may be reluctant to downgrade a manager, as the manager is not likely to promote poor ratings. Morningstar has a consulting business, but it is still in its infancy.

Morningstar's head of research, Justin Walsh, says he decides which managers get covered and when, and that he is not privy to whether the manager has entered an agreement with the company to licence the ratings.

Walsh says that Morningstar has covered small managers without big marketing budgets. "I do not care about that [whether they have signed a licencing agreement]. I want to make sure that I am covering managers that are interesting and worthwhile," he says.

More than 90 per cent of the money going into managed funds is under advice. About 65 per cent of financial planners use van Eyk Research - the most influential of the big three researchers.

Planners pay van Eyk subscription fees to access its research software.

When van Eyk downgrades a manager to an effective "sell", it's big news, because a lot of planners will take their clients out of the fund.

Not even van Eyk Research is immune from criticism. That's because it has business interests that are outside pure research.

It provides advice to financial planning firms on which managers to mix together in portfolios and then clips a fee from that. Critics says that means van Eyk may be reluctant to downgrade a manager who is used in the portfolios.

Its founder, Stephen van Eyk, says if it downgrades a manager to an effective "sell" it will then drop the manager from all the portfolios it runs for financial planners. He says managers do try to influence the outcome of ratings, but that pressure is steadfastly resisted.

The moral of the story for investors is that the various business models of the funds researchers each engender potential conflicts of interest.

But the "pay to be rated" model of ASSIRT does appear to leave it most exposed to conflicts of interest. ASSIRT says if it investigates a fund and anticipates it would not be of "investment" grade, it does not take the rating process any further. But where does that leave investors already in the fund?

Bailey says there are many people of integrity working for research firms, "but there is so much potential for conflicts of interest and there is a reluctance on behalf of the researchers to bite the hand that feeds them".

He says investors should not take the research reports as gospel.

Where do you get it?
It's not available free to the public, but Morningstar ratings and performance data can be found at www.morningstar.com.au and through the tables carried in Money each week. ASSIRT's ratings and funds performance appears in The Australian Financial Review every Wednesday.