Harvard Ethics Scholar: Investment Consulting Swimming with Corruption

Misaligned interests, placement agents, and the disappearing line between consultants and asset managers have corrupted the industry that’s specifically tasked with protecting retirement assets, one academic contends.

Youngdahl(May 7, 2013) – “Consultants…What do they actually do?”

When asked to name the most pressing but unexamined issue facing asset owners, the CIO of a major corporate pension fund recently gave that response.

Investment consulting’s business model has morphed: Many of the industry giants can now not only advise a fund to, say, de-risk or hedge against inflation, but also sell the fund products and services to achieve those goals. In offering more to clients, consultants have destabilized their traditional role as independent advisors. That’s left some CIOs, like the one quoted above, wondering what, exactly, consultants’ role is now.

At least one academic thinks the industry has not only strayed from its roots—it’s gone rotten.

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Jay Youngdahl, an institutional investment expert at Harvard’s center for ethics, has published his arguments in a paper, “Investment Consultants and Institutional Corruption.” He makes the case that consultants are failing at the core tasks they’re entrusted with: safeguarding assets and guiding asset owners.

“The profession failed to protect asset owners in the recent financial crisis and has yet to engage in serious self-examination,” he states. “Much of the reason for the failure can be traced to institutional corruption, which takes the form of conflicts of interest, dependencies, and pay-to-play activity. In addition, a claimed ability to accurately predict the financial future, an ambiguous legal landscape, and a tainted financial environment provide a fertile soil for institutional corruption.”

Youngdahl is a practicing lawyer who represents several labor-affiliated retirement funds. He evaluates the consulting industry as an advocate for the plan members whose assets are at stake. Youngdahl’s paper is not impartial research, but its bias largely aligns with plan sponsors’: the best interests of plan members. His criticisms of consultants echo those told to aiCIO by numerous CIOs and other industry players. 

The actions—or inaction—of consultants during the foreign exchange/custody bank overcharging scandal are one such example.

“Trustees believed that their investment consultants were monitoring this area, as they nearly always recommend some global investments that involve foreign exchange,” Youngdahl says. “They were not.”

Asset owners dissatisfied with their consultants over this episode or any other do not appear, in general, to have translated that feeling into action. Investment consulting is a growing business—and CIOs are generally well practiced at letting go of underperforming managers and service providers. 

For example, in the 2012 fiscal year, Towers Watson increased revenue by 5% to $3.42 billion and boosted net income by a third, year-on-year. The majority of this revenue comes from institutional consulting and asset management services.  (Towers Watson is not specifically named in Youngdahl’s paper.)

One firm that does appear by name, USI Advisors, likewise reports no evidence that its clients share Youngdahl’s negative view of investment consultants.

In August of 2012, USI announced a $1.27 million settlement with 13 pension funds over fees from mutual funds that the Department of Labor argues USI did not properly disclose to clients. The Connecticut-based consultancy also agreed to provide greater transparency as to its fiduciary duties and fee arrangements. The Department of Labor never charged USI with a violation, and the firm contends there never was one.

“USI disputed the DOL complaint but ultimately agreed to a settlement after many years so we could move on,” USI’s President and CEO Bill Tremko told aiCIO, noting that Youngdahl had made no attempt to contact the firm before discussing it in his paper.

“USI is very proud of the fact that the 13 pension plans mentioned have all signed new advisory agreements with USI Advisors continuing our consulting relationship,” Tremko continued. “This is the best evidence of the trust we have established with our clients and is confirmation that those plans understand and appreciate the value and services we provide at a reasonable fee level.”

Rocaton Investment Advisors, another firm the paper mentions, declined to comment. 

Most consultants will agree with Youngdahl on one point: investment consultants have a place in institutional investing—and an important one.

By taking a hard, analytical look at the problems in their own industry, Youngdahl argues that consultants “can spearhead a return to common sense in finance and lead a movement to remove all types of corruption from the field. Those who work in this field should be the men and women, who like an honest and uncorrupted sheriff in an old Western movie, protect their town from the outlaws-allowing its citizens to thrive.”

Read Youngdahl’s entire paper, “Investment Consultants and Institutional Corruption,” here

Related Video Interview:Jay Youngdahl on the ‘Misperception’ of Alternative Investments

Long-Term Investors Reduce Volatility, Improve Corporate Responsibility

Virginia Tech researchers have linked long-term shareholders to improved corporate citizenry and higher stock valuations—but profits take a small hit.

(May 6, 2013) – It's the million-dollar question: Does "responsible investing" benefit one's bottom line as well as one's conscious?

Three researchers out of the Virginia Polytechnic Institute (Virginia Tech) took on this question for public equities, and found the answer is yes.

"Our results are simple to summarize: firms with longer investor horizons invest more in stakeholder capital, which increases stock valuations not as a result of higher cash flow but rather as a result of lower cash flow risk," wrote Ambrus Kecskes (an assistant professor), Professor Sattar Mansl, and doctoral candidate Phuong-Anh Nguyen. All three work in Virginia Tech's department of finance.

The authors found that firms with greater long-term investor ownership boosted stakeholder capital investment by roughly 10%. Further, these stocks had higher valuations (market-to-book) by roughly 5%. However, according to the study, this gain in value was due to reduced volatility, not higher profits. Stocks held largely by long-term investors showed approximately 5% lower profit, sales, and cost volatility.

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Future stock returns for these long-held corporations were 1.3 percentage points lower than those of stocks dominated by short-term investors.

The study was based on a data set of publicly traded US firms covering the years 1991 through 2009. Kecskes, Mansl, and Nguyen divided investors into short-term and long-term, depending on the frequency that they turned over securities. Corporate responsibility scores from analytics firms KLD measured the extent to which each corporation invested in "stakeholder capital", producing positive outcomes for their employees, environments, and communities.

"We conclude that firms with longer investor horizons invest more in stakeholder capital, which increases shareholder value as a result of a decrease in risk," Kecskes, Mansl, and Nguyen wrote. "Taken as a whole, our findings suggest that long-term investors can ensure that firms do well for their shareholders by doing good for their other stakeholders." 

Read the full study, "Can Firms Do Well for Shareholders by Doing Good for Stakeholders? The Importance of Long-Term Investors," here.

Related Article: "Harvard Study: Boards, Not Shareholders, Are Short-Term Thinkers"

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