By Nathan Anderson
If you’ve ever hired a consultant to help choose your investments, chances are you did a lousy job vetting them. More than 74 percent of North American institutions use the services of consultants, yet to this day no institutional investors have truly satisfied their fiduciary duty with respect to consultant selection. Institutions do not perform thorough due diligence on consultants before they hire them and then fail to measure their performance afterward, leading these investors to make poor allocation decisions as a result.
When Amaranth Advisors blew up over bad energy bets, consultants were rightly fired for having recommended more than $200 million in allocations to the fund. Pension funds made strong public statements condemning their advisers for those recommendations, yet were silent regarding their own failures in hiring those advisers in the first place.
A phrase heard commonly in the industry is “no one ever got fired for hiring (insert brand-name consultant here).” Consultants are too often hired for their ability to be high-quality scapegoats rather than for any ability to outperform their peers.
Misaligned motives lead investors to hire consultants based on such factors as name-brand recognition, assets under advisement and breadth of services. None of these criteria replaces due diligence. Compensation structures do not reflect the importance of hiring the right consultant. If the consultant has influence over one-quarter of the portfolio, a quarter of the compensation of those who hired him should be tied to his performance.
Asset managers also need to do better due diligence on their consultants. The typical due diligence review rarely looks past basic presentation materials, references and disclosure statements. But an environment that lacks thorough due diligence enables conflicts of interest.
In 2009, Consulting Services Group, a consultant with $21.5 billion in assets under advisement, was investigated by the U.S. Department of Labor. The department released the results of the investigation, stating that CSG and one of their principals received “undisclosed and unauthorized compensation.” (The firm later settled after agreeing to additional reforms and disclosures.) In 2005, the San Diego City Employees’ Retirement System sued Callan Associates over poor performance stemming from alleged pay-to-play conflicts. At the time, Callan had $2.5 trillion of assets under advisement, making it one of the industry’s largest players. (Callan eventually settled the allegations without admitting wrongdoing.)
The procedure for identifying ethical top-performing consultants should resemble the process consultants use to select fund managers. A detailed review of audited financial statements and operational procedures, background checks on key employees and site visits should be part of a comprehensive vetting process to root out fraud and abuse before it affects performance.
Investors have been almost completely absent at tracking another crucial component of due diligence: past performance. There ought to be metrics to know which of the 1,700-plus existing consultants and pension advisers excel at such distinct skills as asset allocation, private equity advisory or emerging hedge fund manager selection. Consultants with discretionary authority should be required to report their returns according to the same standards they require of their underlying fund managers. Performance of the most highly recommended funds in each asset class should be publicly reported to allow for peer comparisons.
Pension funds face catastrophic unfunded balances in excess of $1 trillion, while endowments and foundations are missing their performance targets by wide margins. Markets break when capital is concentrated.
With more than $7.2 trillion in assets split across the largest ten consultants, one wonders how much cross-exposure to subprime debt losses in the financial meltdown of 2008 might have been avoided if each institution did not employ the same circle of consultants, who in turn made the same allocation and manager recommendations.
To be clear, consultants perform very important services. The shortcomings of the consultant industry today are a reflection of the investors who hire them. Institutional investors must learn to treat consultants as an extension, not an abdication, of their responsibility. The consultant industry will respond to the needs of its consumers, but investors must demand a higher standard first. AR
Nathan Anderson, CFA, CAIA, is principal, alternative fund investments, at Washington, D.C., consultancy Blue Heron Capital, and CEO of ClaritySpring, a software firm focused on hedge fund transparency services.