The financial crisis has radically altered the financial services landscape, with wealth management no exception, and now, as the industry looks to rebuild, both firms and clients are taking a long, hard look at a whole range of business practices - including investment research.

Scorpio’s study on investment research models - for which decision-makers at 83 UK, Swiss and German firms were interviewed - revealed a complex picture with significant geographical variation. Close to 60 per cent of the firms included use a combination of in-house and external research in their investment process, but while this may be the dominant model it would seem firms are increasingly willing to re-evaluate their practices.

Headline figures from the report include the finding that while UK wealth managers clearly favour in-house research, over a third (39 per cent) of UK firms admitted to finding gaps in their current research coverage, indicating in all probability a considerable appetite for alternatives. In Germany this desire for change has already had a significant impact, with over 20 per cent of the German firms interviewed reporting that they had already moved to a research model that operates fully on external, or outsourced, investment research.

Speaking to WealthBriefing in a recent interview, Yannick Mathieu, vice president, European Equity Operations at S&P, said investment research practices within the wealth management space have now reached a “tipping point” whereby firms are more open than ever to overhauling their model. Over the next couple of years the industry can expect to show “measurable change” in how firms use internal and external research, he said, going on to explain that this sea-change is being driven half by clients and half by firms themselves.

Armed with information

One well-noted consequence of the financial crisis, and the huge losses many sustained, is that clients have become more sophisticated in their understanding of financial instruments and demand to be kept better informed about the way their money is run – including knowing the rationale behind investments decisions.

“A crisis focuses the mind,” said Mr Mathieu, “following the decline in their assets clients are increasingly questioning firms’ investment processes.” But this change in clients’ attitudes isn’t solely attributable to the financial crisis, and is a development that has been on the horizon for some time, he said. Clients have been becoming increasingly global in their focus and more sophisticated in their understanding of the various asset classes for several years, he explained, in part due to the amount of information on investing which is now available.

The internet is of course a large part of this, Mr Mathieu said, adding that just as people will often search the internet for health information before going to see their doctor, investors will carry out their own research on potential investments. As such, firms need to be able to give credible answers to queries on an ever-wider range of investment options, he said.

On the side of wealth managers themselves, the crisis has caused firms to re-evaluate their business models, with both the quality of their service provision and their cost bases in mind. Firms are aware that they must invest in a credible research offering, Mr Mathieu said, but they are also understandably keen to keep costs down at a time when balance sheets are still suffering.

But while firms may be averse to increasing their costs through building out a research team with a wider and/or deeper coverage of the investment universe, tightening regulatory requirements are making it increasingly likely that the current status quo simply cannot be maintained. Across Europe, regulatory bodies either have or are looking to introduce new legislation that puts far more responsibilities on wealth managers when they make recommendations to their clients. Demonstrable independence is therefore a heightened priority for firms, and as such time-honoured investment research models are increasingly coming into question.

Sell-side bias

Of the firms included in the study, 70 per cent reported that they use third-party research, and of these a clear majority use sell-side providers, S&P and Scorpio’s report found. But while the use of sell-side research is well-established, and often defended, according to Mr Mathieu, there are several flaws inherent in this practice. The first, well-documented downside is that much of the research coming from sell-side providers has a recommendation bias in that it is aimed at generating “churn”, i.e. stimulating a turnover of trades on a short-term basis. By contrast, the success of a wealth manager’s recommendations will be judged on how well the investment serves the longer-term requirements of the client’s portfolio. This consideration also takes on greater significance when one considers how many of the large international wealth managers are tied at a group level to an investment bank.

In addition the questionable independence and short-term focus of sell-side research, firms will often find it difficult to integrate such research into their offering. “Each firm has a ‘unique selling point’ in the way that they present themselves, and research is part of this,” said Mr Mathieu. “A lot of research is not targeted at wealth managers, and definitely not at their USP.” Related to this is the fact that fixed income is significantly under-represented in third-party research, despite the fact that the asset class is a huge part of wealth management. This deficiency, according to Mr Mathieu, is unsurprising considering that the research industry is driven by hedge funds and investment banks.

The investment narrative

At the heart of the research issue is the way in which it can be used by wealth managers in their relationships with clients. According to Mr Matthieu, for a significant proportion of players, particularly UK firms, research doesn’t play a huge role in their relationships with clients, often because the research in question simply doesn’t lend itself to this purpose.

Although good research has to be in-depth, it is a reasonable assumption that time-poor clients would probably not want to become bogged down with facts when discussing their investment options with their wealth manager. Nor do relationship managers themselves necessarily want to sift through reams of quantitative data covering the entire investment universe before going to their clients with ideas. Instead, according to Mr Mathieu, clients are more likely to appreciate qualitatively-framed research that builds to a solid investment narrative, but as he points out, this means there is “a lot of funnelling work to be done” – work that is perhaps best outsourced.

A further point to be made is that clients – being increasingly sophisticated – are increasingly looking for new investment ideas. But such new ideas can be difficult to access and generate regularly, particularly for smaller research teams, as Mr Mathieu points out, despite the fact that this is just the kind of “value add” that clients really appreciate. Idea generation can be an important way for firms to differentiate themselves, he said.

The role of research in relationship-building

So although it might be difficult for firms to deliver new and insightful research - either because their (relatively small) in-house team cannot feasibly offer comprehensive coverage of the whole investment universe, or because the sell-side research they employ tends to be too narrow and repetitive in focus - it can make all the difference to a firm’s proposition.

According to Scorpio’s research, the traditional approach to investment research does not demonstrate enough value to end investors, despite the fact that research is key to the investment process and client outreach. High quality, qualitative and independent research will not only generate and validate investment ideas, but will also allow client and manager to comprehensively review a sector, asset class, geography or theme - thus generating the type of conversations which underpin the “sticky” relationships firms aspire to.

Changes ahead

From Scorpio’s research it appears clear that firms are increasingly recognising that there are serious deficiencies in prevailing investment research models, i.e. the use of freely available sell-side research in combination with the efforts of a relatively small in-house team. For firms lacking the resources to develop comprehensive research coverage in-house, outsourcing to external providers looks to be an increasingly viable, and cost-effective, option.