To see this article in digital magazine format, click here. 

In February 2010, consultancy Hewitt EnnisKnupp’s proposal to be the outsourced chief investment officer for California’s Ventura County Employees’ Retirement Association (VCERA) was rejected, with the plan’s board citing cost and conflicts of interest—specifically, that Hewitt EnnisKnupp was the fund’s consultant.

Investment outsourcing has been an issue attracting much debate within the institutional investor world, creating concerns over conflicts of interest, confusion about roles, and worries over cost. On one side, when investment consultants move into this area, pension funds such as VCERA often raise concerns about the conflict between neutral advice and implemented investment decisions. On the other side, the pure consultant industry—as of now, a largely unsatisfactory, low-margin, and litigious business—is all too keen to move into what is perceived as a significantly better business model, where fees are asset-based. Critics assert that consultants suffer from a lack of competence as portfolio managers, and that their experience with the administration of a fund is nonexistent. Yet, with public pension funds’ hands tied by growing financial constraints, schemes increasingly are being pressured to hand over the reins of some or all of their portfolios to such third parties.

At VCERA, Hewitt EnnisKnupp had been the fund’s investment consultant for a decade. The bid on the position followed the departure of the praised Tim Thonis, who worked at VCERA as both CIO and CEO; when Thonis resigned, the board refused to pay the firm the amount they were demanding to assume the CIO function, claiming that the role was already the consultant’s implied responsibility. EnnisKnupp disagreed, asserting that their position as a consultant was purely one of asset-allocation advice. A more resource-demanding role, the firm claimed, was outside its purview and, thus, an extra fee was justified. “When a fund loses a CIO, the fund says the consultant should fill that [role] because they had been working with the CIO all along,” according to VCERA Chairman Tracy Towner, a senior district attorney investigator. “I think that’s what caught us off guard—we thought the CIO was taking direction from Hewitt Ennis-Knupp and vice versa.” The California public pension is still without a CIO.

The outsourcing of a fund’s CIO function is just one of many potential conflicts within the space. According to Lee Partridge, San Diego County Employees Retirement Association’s (SDCERA) outsourced portfolio strategist and CIO at Salient Partners, the perceived conflict that arises when outsourcing to a consultant comes from a consultant’s blurred roles at a fund. “If a consultant has a hedge fund-of-funds product but also charges a i% management fee, it becomes problematic when they have an extra layer of fees accompanying their recommendation. They lose their objectivity because they have a product they have incentive to sell to the client.” Partridge draws attention to the question that many industry observers raise over consultants partaking in outsourcing: How can you consult neutrally with someone if you are actively trying to be the de facto asset manager?

At public funds, there is still a general uneasiness about moving to an outsourced model. “Funds like having their own staff who only work for and are only accountable to them,” Partridge says, adding that the current compensation structures at public funds just aren’t working. “At the Texas Teacher Retirement System, it was a real wake-up call when Jim Hille, the fund’s previous CIO, left the $110 billion pension system in 2005 to work at a much smaller endowment. One might speculate as to the exact motivations, but I suspect compensation and politics played into his decision,” Partridge notes. (VCERA’s Towner reinforced Partridge’s claim, asserting that “Tim Thonis was doing an outstanding job. Politics hindered our ability to retain someone like Thonis…[and] now, Tim’s at the Orange County Employees Retirement Association making a lot more money than he made here.”)

Amid efforts by consultants to be and appear neutral when expanding into the outsourcing space, some investment heads have an all-or-nothing approach to avoid potential tension. Eastman Kodak’s Director of Pension Investments Worldwide Timothy Barrett, who worked previously at the San Bernardino County Employees’ Retirement Association (SBCERA) for nearly 15 years, a majority of which was as the fund’s Executive Director and CIO, says: “The decision to outsource should be a decision to outsource fully, or not at all. Any attempt to develop a hybrid approach to outsourcing, where the primary decisionmaker is outsourced and internal employees are left behind to implement, creates conflict,” he says. “That conflict ultimately will result in failure without a top-tier manager constantly overseeing the process. The internal staff have no incentive to assist in the success of the external adviser as they view themselves as competition to the external adviser.”

Despite the range of issues that arise over outsourcing, New York-based management consultant firm Casey Quirk’s Kevin Quirk says that a number of investment consultants have done a good job transi-tioning their businesses toward outsourcing without damaging their consulting businesses or reputations. “I have found that investors are looking for firms to best navigate the waters. They don’t care if it comes from an investment consultant, a money manager, a broad fund of funds, or a dedicated outsourcing platform,” he says. “My view is that there likely will be investment consultants who will orient their business entirely around the business of independent outsourcing going forward.”

From the perspective of the consultant industry, firms as varied as Hewitt EnnisKnupp, Cambridge Associates, and Rogerscasey defend their presence in the space. Without commenting specifically on the relationship with VCERA, Clinton Cary, a Principal at Hewitt EnnisKnupp, says: “With everything we do in our outsourcing business, we’re independent with the advice we deliver. Our structures operate using a compliance function. So, we don’t have compensation structures that change with our advice. Our compensation is neutral.” Looking ahead, Cary believes, consultants increasingly will take over the CIO function at public funds.

Christopher Ailman, the Chief Investment Officer of the California State Teachers’ Retirement System (CalSTRS), echoes that assertion. In regard to relying on external help, Ailman supports the outsourcing model, mainly for smaller funds that lack internal expertise. “It gets down to a question of economics. When you look at anything we do, whether it’s hiring a lawyer or a doctor, we all want the best doctor we can afford. The outsourcing CIO function is a model—it makes sense. I actually like the fact that it prices my services. It’s a new industry, we’re going to see some positives and negatives, and it will continue to grow,” he says, adding that outsourcing the CIO function at public funds will suffer the same deleterious effect many outsourced services do, in that the third party will not be 100% focused on that client and instead will be spread over multiple relationships. “At some point, funds may want that personalized direct service,” Ailman says.

In the case of Ventura, it is understandable why Hewitt EnnisKnupp wants to go from general consultant to outsourced chief investment officer: the fees. It will help ensure their survival as a business; it will possibly compensate them rightly for taking on additional services. However, VCERA’s rejection of their bid highlights the opposite side of that coin: How can a consultant provide neutral advice when it is bidding on more business from the fund?

This is a secular trend, not a cyclical one. The consultant industry has been seeking, and will continue to search for, additional revenue streams and, as a group, has hit upon the outsourced CIO role as a major source of future growth. Whether or not they succeed will depend in large part on whether they can manage these conflicts—and whether pension plans believe they can. —Paula Vasan