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
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
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
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.