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Have investment consultants failed in their duty to clients by being less than aware of the implications of the Dodd-Frank reforms on derivative use and other investment options—or does this distance reflect their unique, clearly defined roles?
When asked about how they’re advising their clients on regulation, a popular response from the investment consulting community is: “We haven’t been addressing this issue broadly with clients as we’re not experts on the implications of Dodd-Frank and other regulation.”
While investment consultants have perspectives on how regulation will impact their work and their clients, they often view their job as being distinctly focused on asset allocation. Among the investment consultant community, the proposed changes derived from Dodd-Frank are largely viewed as beneficial to investors as they increase transparency, reduce systemic risk, and would presumably improve swaps pricing. Some of the largest funds say they have the in-house resources to keep themselves aware of regulation independently.
“Our consultant, Pension Consulting Alliance, is doing their job with asset allocation within the portfolio,” says Anne Sheehan, director of corporate governance at the California State Teachers’ Retirement System (CalSTRS). “We take the lead in educating the regulators on how we use derivatives. Our fund has always been big on transparency and openness. We don’t want regulators to do anything that would harm our ability to use derivatives effectively.”
However, many funds do not have the same level of in-house resources and are clearly concerned with how regulation may impact what they do. Many public plan CIOs have warned that Dodd-Frank may hurt investment returns for pension funds by shrinking OTC derivative markets and cutting opportunities for asset manager outperformance. In January, a survey conducted by research firm Finadium—which collected data from 90 public pension funds and conducted personal interviews with 26 chief investment officers in the United States—found 40% of executives were moderately or very worried about the impact incoming regulation would have on returns made on their portfolios. Only 30% said they were not concerned about the Dodd-Frank Act. “Besides the distraction of hedge funds having to manage registration requirements, plan sponsors were concerned that the OTC derivatives market may shrink, leaving asset managers with fewer options for alpha generation in their current strategies,” the survey said.
Additionally, respondents to the Finadium survey said they believed the regulation would have further long-term effects on the US securities market. “Managers expect that Dodd-Frank reform will drive good participants out of selected markets; people and firms will go where the opportunities are for the broadest cross-section of clients, and this may not coincide with the specific needs and interests of individual plan sponsors,” the survey concluded.
In early January, regulators in the United States approved new rules aimed at scrutinizing Wall Street swap abuse as part of Dodd-Frank regulation, attracting nods of approval by CalSTRS and others in the industry that depend on the derivatives market. In a 4-1 vote for revised regulations, the Commodity Futures Trading Commission (CFTC) approved rules to protect customer money in certain derivatives markets, softening responsibilities initially proposed for Wall Street banks. The new rules call for firms to segregate customers’ swaps money from the firms’ money, while also permitting a firm to pool all its customer money together in one account to lower administrative costs.
CalSTRS is one of many funds nationwide forging ahead with the use of derivatives—closely addressed by Dodd-Frank—despite a volatile regulatory and market environment that continues to attract questions about their use, confusion over their role within a portfolio, and concerns over the future of these investment vehicles to hedge against certain risks.
David Castillo, CalSTRS’ portfolio manager of global equity, states: “We remain cautiously optimistic with the regulatory issues you’re seeing. We have always insisted on segregation of collateral. We’re optimistic this will be a better marketplace in the future. Derivatives remain a tool for us, and we remain cautious and careful in our use of them.”
CalSTRS’ consultant Allan Emkin of PCA acknowledges that derivative use has grown as the size and amount of underlying securities has grown: “We’re much more concerned about speculative use of derivatives and how other parties may use them. The clients want maximum transparency and minimum cost.”
Emkin highlights the different role of investment consultants—in which consultants only provide strategic advice. With the investment management and plan sponsor community responsible for buying and selling investments, consultants often focus their attention on dealing with the “big picture” strategic issues and much less on implementation issues.
In reality, the advisor responsibility of investment consultants to institutional investors should be based on the size, complexity, and sophistication of their clients. Large funds will be more likely to have the in-house resources to stay aware of regulatory changes compared to mid-level and smaller funds, which will seek consultants to take on a very different, broader role—wearing many different hats, says Damian Handzy, CEO of Investor Analytics. “When it comes to regulation, the United States hasn’t seen anything yet—we’re going to see an upcoming wave of regulation as we look more and more like Europe’s highly regulated environment,” says Handzy. “If consultants don’t get in front of this, those firms will turn to someone else to help them,” he says, adding that consultants could certainly run profitable businesses purely focused on the implications of derivative use and other investment options, the Dodd-Frank reforms, and other regulation in the US.
The greater dialogue and concerns within the institutional investing community regarding the impact of Dodd-Frank on the ability to achieve outperformance, however, raises an important question for investment consultants, who have the fiduciary duty to help protect and advise on large pools of assets to the best of their ability. Are investment consultants doing a good job staying abreast of the changing regulatory climate, on the implications of evolving regulations on derivatives, and on financial instruments that would impact their clients?
The current divide between the responsibility of investment consultants to advise on asset allocation and the funds themselves to largely focus on staying abreast of the regulatory environment signals uncoordinated thinking about risk management, Handzy says. “Regulation plays into risk management,” he concludes. “Take the example of when the US temporarily halted short-sales of certain bank financial securities in the wake of Lehman’s crash. That regulatory decision had a profound impact on asset allocation—funds that partook in any hedging strategy became more highly correlated with the rest of the portfolio.”
While the demand on consultants may be more likely to come from smaller funds with less readily available governance resources, consultants with clients of all sizes should stay abreast of regulatory changes, Handzy and others say. Consultants cannot be “all things to all people,” and should focus on what they do well as opposed to stretching their resources. Some of those who say that staying aware of Dodd-Frank is not part of their jobs will be left behind as others capitalize on a volatile regulatory climate that shows no signs of slowing down, Handzy says.