An open letter to product research houses

The meltdown of Basis Capital has highlighted the need for much greater clarity of communication from research houses – particularly when it comes to describing product risk.

With the benefit of hindsight, it is fun to look back and see what the research houses were saying about the risk of the Basis Capital Yield fund - before the event. What we found could best be described as gobbledygook. We see historical volatility and drawdown numbers quoted extensively - which, while historically accurate, completely under-represent the true risk of the product. We see sage comments about experienced risk management teams. We see extensive lists of everything that could go wrong, but no real indication of the likelihood of any of those things occurring or the impact if they did occur.

But we see nothing on the two pieces of information that really matter:
- How likely is a poor outcome?
- How bad could it be?

The poor old adviser or investor is left to sift through pages of Greek letters and other gobbledygook to somehow arrive at their own conclusion on those points – in other words to do the job the analyst should have done in the first place.

How much simpler it would be if every research house report carried a summary such as:
Estimated 1-in-20 year worst case outcome = -50%

This could then be accompanied by the familiar litany of things that could go wrong plus all the caveats and disclaimers required to give the researcher the legal protection they require. This kind of reporting would do three good things for this industry :

It would provide absolute clarity to the market about just how risky researchers perceived any product to be;
It would turn the focus of researchers from compiling lists to thinking deeply about the true risks inherent in any product; and,
It would enable advisers to use informed risk management strategies based on some hard data.

Would it prevent future losses? Of course not. A core function of this industry is to encourage investors to take on risk - and with risk, there will inevitably be losses.

What this type of reporting will do is to reduce dramatically the incidence of the unexpected and catastrophic losses that hurt both investors and the reputation or this industry as a whole.

Let's see if anyone rises to the challenge.

Tim Farrelly is principal of farrelly's, the Australasian financial services industry's first dedicated asset allocation research house.

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