Platforum: Why the FCA will be keeping an eye on the use of research agencies

The FCA’s recent Asset Management Market Study comments the influence of research agencies’ rating of funds has a significant impact on retail fund flows. This hypothesis is hardly ground-breaking but the FCA’s real concern is that the influence of third-party ratings on advisers’ due diligence and selection has a negative impact on competition between asset managers.

According to the FCA, some fund providers are concerned that research agencies will not rate their funds if the fund groups don’t purchase marketing licenses. And advisers may not realise that ratings are “not whole of market”, while relying too heavily on third-party research from just one provider.

Our recent report, The Influence of Research Agencies, shows the FCA’s assumption that advisers are using one research agency is flawed. However, we found the influence of research agencies on advisers is indeed significant and greater than the degree of influence on self-directed investors.

The influence of research agencies on advisers

Platforum data shows 61 per cent of advisers use third-party fund ratings and research for their fund selection and due diligence. The percentage of advisers using research agencies has not really changed in the last two years, but the level of assets being influenced by research agencies has increased. Large advice firms employing significant numbers of regulated individuals and smaller advice firms advising high-net-worth clients are most likely to use third-party fund research. Unsurprisingly, independent advisers are twice as likely to use research agencies than restricted advisers.

The influence of third-party research on adviser firms that outsource fund selection is less extensive but some research agencies have diversified their propositions to offer their own discretionary fund management services. Model portfolios managed by agencies like FE, Morningstar and Square Mile are increasingly available through adviser platforms and are competing with model portfolio services from traditional DFMs.

Despite this competitive environment, model portfolios represent a significant growth opportunity for research agencies, giving them influence over a pool of advisers that their research struggles to reach. All the research agencies that we spoke to will only use funds they rate in their model portfolios (although robust Chinese Walls are in place between the different divisions).

Research agencies have moved into discretionary fund management in response to the trend for advisers to outsource investment strategies. However, we see evidence that the trend to outsourcing is reversing. Adviser firms are more likely to use third-party research if they offer in-house bespoke DFM services, create their model portfolios in-house or pick single-strategy funds for clients. So if the trend to outsource continues to reverse in favour of in-house investment strategies, the influence of third- party research agencies on advisers seeking to build in-house investment strategies looks set to increase.

Are advisers too reliant on quantitative ratings?

The most widely used research agencies by advisers – FE and Morningstar – include quantitative ratings in their suite of ratings. Most research agencies require a three-year track record before awarding a fund a quantitative rating. While few advisers solely use quantitative ratings, many advisers use the backward-looking quantitative ratings to filter funds before looking at qualitative ratings, which aim to provide a forward-looking view of a fund’s likely future
performance.

Our view is that research agencies have significant influence over advisers who pick funds and their influence will increase as the trend to in-sourcing fund selection gathers pace. But most advice firms do not confine their use of research agencies to just one firm, most use two or more. It might be more prudent for the FCA to consider whether the way in which advisers use quantitative ratings means they are relying too heavily on past performance, which could mean that some funds unfairly fall at the first hurdle.

Rodolfo Crespo, senior analyst at Platforum