Consultants (and Asset Owners): This Is Why You’re Not Innovating

Though investment consultants are under attack for failing to innovate, asset owners may also be at fault for enabling their stagnation, according to research.

Such lack of innovation may be due to the nature of the contracts that asset owners have with consultants, according to Gordon Clark of Oxford University and Ashby Monk of Stanford University.

“Enabling and facilitating decision-making is not quite the same as setting the parameters for an effective short- or long-term investment strategy.” —Clark and MonkMost standard contracts are open-ended, the paper said, with room for ambiguity in duration, precise nature of the provided services, and specific fees. Instead of nailing down the details, most contracts rely on conventional norms to fill in the rest of the agreement.

According to the authors, the ambiguity could provide both investor and consultant room to maneuver through the risks and uncertainties of the markets.

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These unrestricted contracts also mean consultants serve different roles for funds of varying sizes to fulfill their specific needs, the research said.

For smaller funds, consultants are likely to play an integral part of how investment decisions are made, according to Clark and Monk, while they tend to act more as facilitators for middle-sized funds.

And for large funds, consultants are sources of independent insight—“a not-entirely-welcome reality check on the aspirations of the fund’s senior executives,” the authors said, requiring them to have more specific roles and responsibilities.

However, the same ambiguity in contracts could also explain why consultants may not be incentivized or motivated to “promote, innovate, and change in the face of market dislocation,” the paper said.

In addition, a standard contract between asset owners and advisers is silent on the topic of performance, according to the research.

“Enabling and facilitating decision-making is not quite the same as setting the parameters for an effective short- or long-term investment strategy,” the authors said. “Investment consultants are deliberate in setting boundaries on their responsibilities in this regard.”

The authors claimed this ambiguity was hampering the ability of asset owners to deal with new market realities that emerged after the financial crisis.

“Where market disjuncture breaks with past industry practices and the available scope for incremental adaptation, asset owners may be forced to confront their own inadequacies and the costs and consequences of conventional behavior,” Clark and Monk said.

The paper said small funds are likely to outsource both strategy and implementation functions, medium-sized funds would form a closer relationships with consultants to be more engaged in their decision-making, and large funds would specify advisers’ roles to add value to the investment staff’s knowledge.

Read Clark and Monk’s “Contested Role of Investment Consultants: Ambiguity, Contract, and Innovation in Financial Institutions”.

Clark, Monk

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New Jersey’s top pension investment officials argued for the validity of alternative allocations during a senate oversight hearing Thursday, while a union-paid consultant denigrated the strategy as evidence they had “drunk the Kool-Aid.”

Questioned by lawmakers, State Investment Council Chairman Tom Byrne repeatedly pressed the message of value. The lion’s share of $600 million spent on external managers last year compensated alternatives managers for strong performance, he pointed out.

“The more we make in profits, the higher our incentive fees are going to be,” said Byrne, member of the state Democratic establishment and head of an asset management firm. “Would you pay $334 to make an additional $1,800?”

Investment professionals with sufficient “specialized training aren’t going to work for 100 grand.” —NJ Pension Chair Tom Byrne

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A consultant paid by AFL-CIO, America’s largest union, testified that the $80 billion pension fund’s diversification strategy hadn’t worked, and that alternatives may have no place in a public pension portfolio to begin with.

The union representative on the state pension board, Adam Liebtag, broadly agreed with his testimony.

“The staff at the Division of Investment managed 74% of the pension fund at 1/60th the cost of fees paid to outside hedge funds and alternative investment managers, so we have to wonder, are the large hedge fund fees really justified by the returns?” Liebtag asked. “The only people getting rich off the New Jersey pension system are hedge fund managers.”

The pension fund has already struggled to attract and retain talent for its in-house investment positions due to low and tightly controlled compensation packages, even relative to other US public funds. The people with sufficient “specialized training aren’t going to work for 100 grand,” Byrne pointed out.

A top investment position for the fund’s $36 billion equities portfolio is currently open, for example. The salary will be in the region of $100,000, with no opportunity for performance-based bonuses.

The New Jersey Department of the Treasury disputed a number of the arguments and allegations made during senate hearing. The Treasury’s statement, provided to CIO, is reproduced in full below.

The mission of the Division of Investment is to achieve the best possible return for pension fund beneficiaries at an acceptable level of risk, while using the highest fiduciary standards. The comments from some speakers and legislators at today’s hearing criticized the same Division of Investment asset allocation strategy that has significantly mitigated risk and outperformed benchmarks, earning billions in additional returns for beneficiaries. Ultimately, it is the view of the division that a diverse portfolio including both traditional and alternative investments is likely to lead to better risk-adjusted returns over a meaningful period of time. This belief is corroborated by the approximately $35.6 billion in gains generated by the pension fund using this strategy over the past four full fiscal years. This equates to an 12.1% return compared to the assumed long-term rate of return of 7.9%.

To also clear up some misleading remarks and false hypotheticals that were repeated several times during the hearing: in FY 2014, alternative investment and global diversified credit managers along with advisors for emerging market equity and high-yield fixed income portfolios were paid a total of $265.4 million in management fees and expenses. In addition to management fees, alternative investment managers earned $334.8 million in carried interest (performance allocation) based on the high returns they generated for the fund. It was repeatedly suggested by some at the hearing that it would have been a better decision for the state to have used the combined amount of these fees and carried interest elsewhere in the budget. This is a false hypothetical. Had the state not invested with these managers the $334.8 million in carried interest—along with $3.7 billion in gross gains—would not have existed.

Furthermore, some critics repeatedly cited the state’s losses in hedge fund investments during the Great Recession while advocating an asset allocation strategy that invests less in alternatives and more public equities. What these critics fail to reference is that during the same period of time losses for the state and many of its peers were far greater in public equities than in alternatives.