PA ANALYSIS: Turning the screw on fund ratings firms

Nearly three months on from the Financial Conduct Authority’s final report on its ‘Asset Management Market Study’, the screws look set to tighten for one of the sector’s key ancillary businesses.

Investment consultants are major gatekeepers to £6.9trn of assets currently managed in the UK, influencing and directing fund flows. With more than £3trn held in UK pension funds and other institutions, and £1trn under management in retail funds, it is clear why the larger piece of the pie justifies the brighter spotlight being shone on it.

Currently unregulated, the FCA has recommended to the Treasury that investment consultants, in this context, come under its remit. But the paper seems to have overlooked or failed to clarify where investment consulting firms, ratings agencies and research companies used by retail intermediaries sit in the review. What is the future for these businesses? How might their business models need to evolve?

Toe the line

Some commentators believe that because they purely provide information to financial advisers and wealth managers, to use or ignore at their discretion, and because those entities are the regulated points in the chain, that is sufficient.

Others argue that all entities contributing to the process ought to be regulated, forcing greater accountability for any influence they may have on investments made.

Graham Bentley, founder and managing director of GBi2, an investment marketing consultancy, believes the rule should be that anyone providing information used to make a decision over someone investing should be regulated.

“The issue is that there are so many links in the chain – the fund groups, the platforms, the life companies, the research groups – and they are all taking money out of the process,” he says. “I believe each one of those touch points along that line that contributes to the decision-making process needs to be regulated.”

With more and more wealth managers and advisers relying on buy lists, the line between what constitutes information or advice has become increasingly blurred.

“And because [the rating agencies] aren’t regulated, there is no accountability. How do you know if they are any good at what they do?”, Bentley asks.

Research published by the FCA to support its asset management study found best-buy fund lists compiled by direct-to-consumer (D2C) platforms favour affiliated funds and those paying higher commission.

Indeed, Bentley has concerns over the dispersion of quality between D2C fund lists and those aimed at intermediaries.

“The thing that strikes me is the relative lack of difference in quality between a D2C list versus those provided from one of the research and ratings agencies,” he says.

He adds the problem with many fund buy lists, and why they start to look so similar, is that so many tend to use past performance as their starting point.

“Whereas you could have a value investor, who may not have had a great time of it lately, look as though they should not be on a list, yet at the same time the researchers claim to be forward-looking. It’s just not clear.”

Benchmark pressure

Bentley also points out the over-reliance on benchmarks, which he says can be manipulated to demonstrate a more attractive comparable performance measure: “People use the benchmarks that make them look the best.”

Gill Hutchison, research director at The Adviser Centre, also notes the FCA’s obsession with benchmark outperformance, suggesting it is limiting.

She says: “There seems to be an unfair focus on how funds are compared in terms of performance. Some are not absolutely focused on performance but the report didn’t mention risk-adjusted returns, those delivering a stable income or achieving capital growth objectives.

“This seemed a bit unfair because groups are providing all sorts of different products that are not just designed to outperform a simple index such as the FTSE.”

Richard Romer-Lee, managing director of Square Mile Investment Consulting and Research, says because those using their model research and ratings come under the FCA’s remit, there is “some regulation in the chain”.

While the FCA is yet to call for these businesses to be regulated, Square Mile, and others, say it would be a welcome move.

“Some of what we do is eligible for regulation and some isn’t,” says Romer-Lee. “The fund research and consulting is on an advisory basis, it is not a regulated activity because the clients to who we are providing that information are regulated.

“That said, running the regulated subsidiary – our model portfolio service – is a
regulated business because we have a discretionary licence.

“So while some of what we do is regulated and some is not, we have adopted the FCA’s conduct of business rules across our entire company because we cannot have a dual culture, it just wouldn’t work. And also because it is the right thing to do.”

Conflict of interest

The report raised questions over conflicts of interest. Many research houses insist upon Chinese walls between their research and ratings businesses, and claim revenues only come in if the particular fund group whose fund is being rated chooses to use the logo on its marketing collateral, for example.

While, in theory, this is fair enough, does that then open up the possibility of ratings only being given to those funds more likely to want to use the licence, ie the good ones?

Fundhouse runs a different model. Rather than asking fund groups to pay to use its research, it asks the adviser. Rory Maguire, co-founder, believes it eradicates any risk of biting the hand that feeds him.

“If the fund managers are paying your salaries, it increases the chance of any Chinese walls becoming porous,” he says. “How do you dish out a critical rating to companies that constitute such a large part of your P&L? These are not arbitrary subsidies.”

Claiming to be the only regulated UK entity offering fund ratings, he says a clear differentiator of his company is that it offers negative ratings, which he believes eliminates any potential for bias.

Fundhouse also recently made its fund selection track records available to the public in a push for greater transparency.

Geoff Mills, director at RSMR, sees it from the opposite perspective.

“At the moment, this aspect of the paper doesn’t apply to us. We can’t say [regulation] won’t ever happen but we are not worried about it. We all come from regulated backgrounds, and we operate as though we are a regulated entity.”

“There are funds on our rated list that don’t pay us a penny because they don’t use the logo. But we don’t take them off the rated fund list. That is what the FCA was implying, earlier, but it doesn’t apply to us.”

We know the cost of running these studies must be huge and a wider regulatory umbrella may be necessary to separate the wheat from the chaff. But it sounds like for most of the organisations affected, it would just mean business as usual.

So as ongoing reviews of the funds industry continue, are we actually learning anything, or is the FCA once again using the oft-cited regulatory ‘sledgehammer to crack a nut’?



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