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In communist East Germany, citizens were only able to buy a limited range of products. Vita Cola, Juwel cigarettes, and Kristall vodka were some of the few brands that lined the shelves of the city’s stores, and these were dutifully bought by comrades who had no other choice. The market was strictly controlled by government forces, and if something wasn’t authorised for purchase by those in control, it was not available.
On the other side of the Iron Curtain, West Germany was enjoying free-market capitalism, which allowed its citizens an ever-growing selection of items from all over the globe. If they wanted ham from Spain, they could get it imported. If they wanted cheese from a small farm over the border in Austria, they would drive over and get it. Even home-grown items came in various forms, with a range of packages and ingredients. The only limits were their capital base and their imagination.
Speak to the most sophisticated European institutional investors in 2014, and you could be forgiven for thinking they were back on the wrong side of Check Point Charlie.
The problem? Investment consultants’ buy lists.
Rationally, even the largest firms cannot hope to research and carry out due diligence on the many thousands of funds available to investors around the world. There are simply too many, and hundreds are too small, too old, or too unlikely to be of interest to enough investors to warrant an investigation. However, it is the process—and not necessarily the product—of compiling these lists by some firms that has angered CIOs.
A Litany of Complaints
“Consultants don’t research every manager. They can’t, despite what they say and despite having as many manager research staff as they have… or claim to have,” says one CIO based in the UK. (As this is an emotive topic—and investors must continue to work with these companies—aiCIO assured anonymity of both investor and consulting firm for this specific article.)
“I constantly get calls and emails from people asking for meetings and putting together what, on the face of it, seems some decent information about process and returns,” another CIO says. “However, it is difficult to get anything to happen if the conversation stalls at, ‘What is your buy rating with X consultancy?’”
The problem seems to be most acute in the UK, where an investment decision can only be taken or agreed by someone who is registered by the Financial Conduct Authority. Consultants, bankers, and fund managers fall into this bracket; trustees and many investment committee chairs and CIOs, who in theory have fiduciary responsibility for deploying the cash, do not.
A common refrain from CIOs: “At times it’s difficult to get any traction unless the consultant is willing to research the firm and give it a rating.” This lack of willingness by consultants to expand their—and their clients’—horizons is one of the major issues for investors as it can lead to poor performance from their portfolios.
“Some have deep-rooted biases for the ‘favoured managers’ even after there are massive red flags waving about inadequacies at their favoured institutions,” says one CIO. “They miss new opportunities religiously and, frustratingly, they turn good risk-taking managers into risk-averse dweebs so fearful of losing money that they prioritise capital preservation over returns once they have been blessed with the assets from the advisor’s clients. This means you pay 2/20 for lame, bond-like returns.”
But we know investors should be looking at the long term, don’t we? Well, according to some, not that long term.
“I think consultants are slow to the party in recognising good managers and take too long to upgrade good and emerging managers,” adds another UK-based CIO. “Some advisors are also narrow in their preferences, and stick with tried and tested names. A handful of them buck this trend, but it can also be challenging for managers to get in front of them. I’d like to see better systems in place at advisors for getting into new ideas early and less protecting when views change.”
But it is not just potential new managers who are being neglected, investors grumble.
“Many managers tell me they haven’t seen our consultant in years—particularly if they aren’t one of the ‘chosen few’,” rages one investor. “In asset classes like infrastructure there are only a handful of funds raising capital at any given time, but investment advisors’ coverage of them is appalling. If a fund actually manages to get a ‘buy’, it is normally rated just in time for final close, meaning clients miss any early-mover fee advantages. This has meant that, for any infrastructure investments, we typically make them sans advisor and then just ask them for a Section 36 letter [an agreement through which a consultant approves of the investment, despite not conducting a thorough investigation], which isn’t great practice. The investment advisor, on every occasion this has happened, has then followed us, the investor, into the fund with other clients. It’s like we are doing their research for them.”
One CIO was angered when a failing manager was re-proposed rather than removed from the buy list, but at a lower cost than before: “Instead of redeeming from the manager, they just asked the manager for lower fees. Cheap fees don’t make up for inferior performance.”
Every large investor will have a horror story about “the fund that got away” due to their consultant’s perceived reluctance or ineptitude, but for many, consultant buy lists are distorting the market for both their own clients and others.
“One should be wary when firms with large volumes of money under advisory—e.g., one of the largest has $250 trillion globally—push money to certain fund managers,” says one European CIO. “This creates all the inefficiencies that are well-stated about excessive asset gathering—e.g., dilution of alpha, moving the market, fund managers’ time being used for client servicing. We would rather uncover managers not on the buy lists of major consultants for these reasons.”
There is another concern in this regard, which is more frustrating than distorting.
“There will be some real gems that are found by consultancies, and for some of those gems there will be restrictions on closing to new monies unless you happen to be a client of XYZ consulting firm with whom they have some sort of arrangement/agreement,” says one European CIO.
Going Alone
Indeed, many investors have dispensed with consultants altogether. Some of the largest pensions in Europe have built up internal resources to identify, research, and carry out in-depth due diligence on fund managers themselves.
“From my perspective, the focus on manager buy lists—and not on what the appropriate strategy should be—shows the real lack of alignment between pensions, their trustees, and consultants,” says one CIO who has not used these firms for years.
Consultants, if they have managed to read this far, should not entirely despair, however. Some investors think buy lists can be helpful for small to mid-sized pension funds and other institutional investor asset pools, but close scrutiny is needed.
“Investors should be mindful that buy lists are just the view of a handful of individuals and are not the panacea,” says one CIO. “Views can also be varied between advisors, which means there is a wide market of views to choose from out there.”
What’s clear is this: A split has appeared in the market between the smaller and larger, more sophisticated investors. If consultants want to rein this latter group back in, many need to buck up their ideas, and fast, or they will lose them—and their billions in assets—forever.