Buy Lists: How the Sausage Is Made

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Somewhere in the United States there is a frustrated money manager fed up with the politics and bureaucracy of buy lists. Despite his innovative work and stellar performance, he is unable to get placed on this list—the database of fund managers approved by the research division of an investment consultancy—because, in his mind, he doesn’t know the right people. He hasn’t schmoozed enough or marketed himself well enough. He comes from a relatively small hedge fund—too small for consulting firms to notice.

His anger raises questions about the validity and fairness of buy lists, which have been developed to track managers’ performance numbers, as well as assets under management, portfolio manager tenure, and style information. Are they constructed in a fair and reasonable way? Are they created objectively—purely based on skill and performance? Or, is there more that goes on behind closed doors in the way these buy lists are constructed?

While consulting firms say that the construction of their lists is unique, transparent, and thorough, other industry sources say that the process of getting placed on a buy list is not always objective. One source, who preferred not to be named, referenced a variety of educational programs and industry events offered by Callan Associates’ Center for Investment Training—more widely known as “Callan College”—where, in addition to gaining greater insight on the asset management process, communication best practices, and presentation skills, fund managers have allegedly attended to make strategic connections with the consultancy, for a hefty price, with the hope of upping one’s chances of being pitched to their clients. The general thinking among fund managers’ attendance at these programs is a Fear of Missing Out (FOMO) mentality. “If you don’t go, you’re screwed,” says one fund manager.

Like other investment consulting firms worldwide, Callan has faced numerous allegations over conflicts of interest in recent years, stemming partly from its educational programs frequented by fund managers. In 2006, for example, Patrick Patt—a participant in the Illinois Teachers Retirement System (ITRS) defined benefit plan—alleged that Callan, a former top consultant to the state’s teacher retirement fund, acquired millions of dollars in fees from money managers, including managers that the consultant subsequently recommended for lucrative state work. Consequently, by taking fees, the San Francisco-based firm violated its duty to serve only the interests of the state’s teachers, according to the complaint. Meanwhile, the suit alleged that Callan was receiving fees from money managers, who paid to attend Callan seminars such as “Callan College.”

Also in 2006, city officials in San Diego alleged in a lawsuit that the consulting firm recommended that the city “employ investment managers from whom Callan received under-the-table fees that were not disclosed to the city.’’ In these deals, often known as pay-to-play, managers allegedly were recommended for pension-fund management by Callan if they spend up to $50,000 to attend “colleges’’ or “institutes’’ or buy marketing services offered by the firm.

When questioned about Callan’s response to the perceptions of conflicts of interest and scrutiny that its training seminars have encountered, spokeswoman Nancy Malinowski asserted that the college poses no conflicts of interest between the consultants who run the seminars and the many fund managers who attend them. “People who attend the college are not clients, since it’s open to everyone,” she says, acknowledging that all consulting firms face the same basic conflicts. “Firms that claim not to have conflicts either do not understand their business or are purposely oversimplifying the issue to avoid talking about how they manage them.” Yet, she adds that having potential conflicts does not equal unethical behavior. “Ethical firms, such as ours, take an honest approach to acknowledging potential conflicts and managing them aggressively through complete transparency and disclosure, strict policies and procedures, an ongoing monitoring process, and adhering to a code of ethics to ensure they are never realized in advice to clients.”

The Callan issue represents just one potential conflict in the creation of a database from which asset owners draw. Fund managers who have failed to make these lists—universally hesitant to speak on the record for fear of further damaging their chances—say that the process should be based purely on results, as there is no room for favors and pulling strings when you’re dealing with other people’s money and executing a fiduciary duty to be fair and honest. “Many consultants will say they don’t like the term buy lists because they indicate a lack of due diligence over the entire marketplace,” says Matt Crisp, previously at Watson Wyatt and now Principal & Founder of eVestment Alliance, an Atlanta-based data and analytics firm. “At larger national or global consulting firms, it can sometimes take a manager a couple of years to be highly rated or be on a buy list, after sufficient meetings with their research teams and gaining a track record validated over time,” he notes.

The complaint that buy lists are exclusionary is a common one. Crisp’s comments reflect one of the major issues that many in the industry observe with the buy-list approach: namely, that these lists often implement self-imposed blinders that may exclude new, fresh talent. Furthermore, critics of the buy-list approach claim that each client is unique, and that the strategy simply facilitates laziness and the ability for consulting firms to skip doing their homework—ranking name-brand managers rather than the ones who are truly exceptional. In an effort to keep costs low, they say, you get mediocrity.

Perhaps an admittance of limited resources more than actual consultant satisfaction, some funds understand the drawbacks of buy lists—and accept them regardless. Samuel Kunz, Chief Investment Officer of Chicago’s Policemen’s Annuity and Benefit Fund, says that the positives associated with buy lists—providing added value to schemes that lack in-house expertise, for example—are reflections of constraints. “Buy lists highlight the fact that consulting firms have limited resources that they can allocate to a given search,” he says. “If you go with well-known managers, it’s often easier to recommend them across a larger spectrum of clients despite the number of studies that have come out in recent years showing that small managers outperform.” The tendency to flock to larger managers, which Kunz alludes to, highlights an underlying conflict consultancies deal with when constructing their lists: the tension between business risk and alpha generation. However, are there alternatives to this ranking system, and are buy lists thus a necessary evil? “I understand why consultants have these lists,” Kunz says.

Interestingly, many consulting firms defend their lists—with most refusing to term them “buy lists” at all. “At NEPC, we don’t sell investment products or receive compensation from investment managers, and we refresh our list every 12 to 18 months. When we research, it’s completely independent,” says NEPC’s Chief Investment Officer, Erik Knutzen. “We do quantitative analysis to identify fund manager candidates. We then perform intensive qualitative analysis seeking to identify a key investment thesis for the strategy. Our reasons for taking a manager off a list usually have to do with organizational changes and changes to investment process,” Knutzen adds, noting that the firm generally does not remove managers due to short-term performance. “We try to maintain a long-term view. We avoid buy high/sell low phenomena with regard to managers,” he explains, adding that the firm avoids hiring solely based on good performance. “This is also not a perfect science.”

Perhaps, for the meantime, buy lists are the best option when accepting the reality that consultants are notoriously stretched and, therefore, must focus their resources narrowly, to the detriment of the talented yet overlooked fund manager. The buy list may be, in fact, a necessary evil—a way to be efficiently selective. The danger of these lists, however, stems from the perceptions that fund managers get ranked for reasons other than performance, currying favors from consulting firms by attending “colleges’’ or “institutes,” for example. The danger also stems from a perceived laziness and staleness among consultants. In the final calculation, however, when speaking of buy lists, Winston Churchill’s famous dictum on democracy rings true: Buy lists are the worst form of manager selection except for all others.

—Paula Vasan