CIO of ascendant
How Do You Solve
a Problem Like
An industry upended.
Reported by Kip McDaniel
Illustration by Robert Hunt
The numbers were ugly.
Investment consultants, the number crunchers claimed, were powerful, pervasive—and useless.
Not only that, but consultants were driving up profits by perpetuating complexity, the two Oxford dons and a University of Connecticut professor asserted in their 2013 paper. Institutional investors who hired these rascals were in turn timid, misinformed, and extremely interested in ass-covering.
In short, the authors concluded, "we find no evidence that consultants’ recommendations add value."
The reaction from the investment industrial complex was a curious mix of hostility and malaise. Greenwich Associates—the source of the paper’s data and an admired information provider for investment consulting and other institutional topics—privately condemned the study and rethought its policies for sharing its coveted data. Consultants publicly dismissed the research, citing a variety of real or perceived deficiencies. Asset managers, whom the paper proved rely heavily on the approval of consultants, had no incentive to bite the hand that feeds them. And institutional investors largely ignored it—for there are many concerns greater to under-staffed investment offices than invectives hurled from ivory towers.
Which raises the question: Are they all delusional?
In an attempt to answer that question, I traveled from the fifth to the twelfth floor of 255 State Street, home to both investment consultant NEPC and Chief Investment Officer’s Boston satellite offices. Awaiting me were Tim McCusker, CIO of the firm, and Managing Partner Mike Manning. The topic of conversation: the tensions that exist within the industry in which they are ascendant, and the Oxford paper.
"It’s a better headline than analysis," Manning said with a chuckle when I placed the paper in front of him. Both he and McCusker read it shortly after it came out, and had been warned before our discussion that I was going to ask them to defend their industry and value proposition. Neither man—jovial and in casual Friday attire as we sat in McCusker’s corner office overlooking the harbor—disappointed.
"The paper caused a stir—of course it did," McCusker said. "And of course we looked into its assertions seriously. We actually don’t disagree with all of it."
"Take, for example, where it says that consultants don’t necessarily chase returns," Manning cut in. This is, in fact, one of the key findings of "Picking Winners? Investment Consultants’ Recommendations of Fund Managers." Soft factors, such as a manager’s investment process, drive consultants’ recommendations as much as past performance, the study found. "We absolutely agree with that, because consultants shouldn’t just chase returns. You certainly shouldn’t be paying someone to just find the ‘hot dot’"—a term to describe a manager in the upper left-hand quadrant of a risk/ return chart, implying high returns with low risk. "You can find that for yourself. Anyone can return-chase—"
"—Everyone does!" McCusker chimed in, laughing. The two have an enviable rapport, McCusker playing the role of Jony Ive (the design genius behind Apple’s products) to Manning’s Tim Cook.
"It actually can be helpful to look for laggards," Manning continued. "In extreme market environments, long-term value-adding managers can underperform—so it makes sense to look for laggards in extreme markets and see if their process will revert to success when markets return to normal." In essence, even billionaires have bad years. "Believe us, we aren’t going to recommend a manager who is always crappy—but we’re not going to refuse to look at them just because they’ve had a poor year or two."
Unsurprisingly, neither McCusker nor Manning would argue with the paper’s assertion that investment consultants are hugely influential in terms of asset flows to and from individual asset managers. Humbleness only goes so far, and if any consulting firm deserves a bit of pride, it is theirs.
According to data (also from Greenwich Associates), NEPC has risen rapidly to the top of the business. Each year, the research firm interviews institutional investors from across the country. Among many other questions, they are asked which investment consultant is most important to them. While the influence of traditional industry giants like Mercer, Cambridge Associates, Aon Hewitt, and Towers Watson has diminished, NEPC has experienced the opposite. In the most recent round of interviews, 10% of the 1,277 institutional investors surveyed cited NEPC as the most important consultant. The firm topped its next competitor by more than two percentage points— the same amount its influence score rose since 2012. Taking into account these investors’ assets, only Callan Associates—a favorite among large public plans—topped NEPC.
Serious critics of the industry—and there are plenty—point to two fundamental problems: The failure to innovate and the failure to manage conflicts.But the paper’s third, most damning critique roused McCusker and Manning into playing defense: Consultants, the authors asserted, add no value for their clients.
"We have big issues with the data," McCusker said, turning serious. "Issues with the sample size, quality of analysis, and, most importantly, that they’re only looking at active US equities."
"Large cap active equities are not where consultants hang their hat," Manning added.
"For every $100 we make, maybe $1 is for recommending the hiring and firing of active US equity managers," McCusker said. "Also, because the study is only looking at that one slice of the portfolio, it avoids the larger asset allocation picture." Active investing is a zero sum game, he pointed out. "If these managers are losing, someone is winning—and that is likely the top hedge funds and other areas. And this study ignores our larger recommendations to, perhaps, get out of long-only active equity and move parts of the portfolio into areas where there is value. It’s an asset-allocation level discussion that’s missing in the study."
"Plus, we can’t expect to be right 100% of the time when recommending managers," McCusker continued. "Good asset managers get like 51% of their bets right. There needs to be a similar standard for consultants, because the more you diversify—and that’s a good thing—the more you’ll always have some things that simply don’t work."
But perhaps it is investment consulting that doesn’t work. Serious critics of the industry—and there are plenty—point to two fundamental problems: The failure to innovate and the failure to manage financial conflicts.
The first relates to the "nobody ever got fired for hiring IBM" syndrome. Different consultants have different reputations in this arena: NEPC, for example, has led the charge on risk-balanced investing while others have lagged. Given consultants’ clientele, however, few are willing to push beyond conventional wisdom. Many would argue that this is out of necessity, for the downside of putting a client in a bad investment can outweigh the upside of a good one. By way of example, the steady returns spewing out of a certain split-strike conversion strategy may have sounded extremely enticing circa 2007, but every consultant who avoided Bernie Madoff was happy to not "innovate" in his direction.
The second tension arises because consulting is not a hugely profitable business. Traditionally, consultants charge an annual fee of approximately 0.02% of a client’s assets, and less for larger clients. On a $1 billion portfolio this can seem substantial, but the infrastructure needed to run an institutional-quality consultancy is equally as substantial. Consultants aren’t destined for the poorhouse, but with few new multi-billion clients being created out of thin air, they have two choices: steal clients from competitors, or get into new—more profitable—lines of business.
The first strategy can work, if slowly. Firms like NEPC, Callan, Summit Strategies Group, and alternatives specialist Albourne Partners are gaining traction, according to the Greenwich Associates data. But this is a hard slog: Consulting relationships are traditionally sticky, and differentiating between firms can be tricky.
“We have big issues with the data.
Issues with the sample size, quality
of analysis, and, most importantly,
that they’re only looking at active
The same data also tells the story of the second method of business growth: Diversifying. While on the surface stalwarts like Mercer, Towers Watson, and Russell Investments seem to be losing market share, observers speculate that this isn’t the entire tale. Instead, these firms are shifting (or upselling) advisory clients into their outsourced-chief investment officer (OCIO) services, in which clients traditionally give up discretion over at least manager selection and pay closer to 0.2% per annum—a ten-fold increase.
Negotiating the tension between offering advice only for the benefit of the client and trying to sell them on a more expensive (and fundamentally different) relationship can be difficult, Manning and McCusker admitted.
"It’s about managing the culture," McCusker replied when I asked how NEPC reconciles these competing interests. (The firm advises on $875 billion in assets, compared to only $5.1 billion in its nascent OCIO business, according to the 2015 Chief Investment Officer OCIO Buyer’s Guide.) "Compensation also needs to be aligned. Plus, just like consulting, our OCIO model isn’t entirely scalable."
"We were actually late to the OCIO game," Manning interjected. "We lost clients because they wanted OCIO and we didn’t offer it."
Other providers echoed NEPC’s rationale: This is a business that people are demanding, conflicts be damned—and just trust us to manage it.
Someone unfamiliar with the consulting industry might imagine it’s conflicted in the same way as ratings agencies, as both make money by telling potential investors if financial products and services are worth buying. But unlike ratings agencies, who depend on banks for high-margin contracts, there’s no evidence of consulting firms directly taking payment from asset managers in exchange for recommendations.
Which is not to say managers don’t write checks to advisory firms, because they do. Some prominent operations count managers as consulting clients, provide them research, or charge for access to events where the consulting firm and its clients will be in attendance. Whether consciously or unconsciously, the reasoning goes, these firms might favor asset managers who contribute towards the businesses’ bottom lines.
“If you are in the consulting business for any length of time, you develop a list of favorite managers—you can’t help yourself.” —Greg Allen, CallanCallan Associates is an oft-cited example. In addition to investment consulting (where pension funds, nonprofits, and other investors pay for services), the firm has an asset management consulting arm and the Callan Institute, a conference and research business. Both units depend upon asset managers paying substantial amounts to Callan. The Institute—and its annual January conference in San Francisco—was the most brought-up potential industry conflict during interviews for this article.
Callan insists that it has no "sponsors" for the Institute, just "clients." These "clients" receive many benefits, they assert: "published research, real-time insights, conferences, and workshops." Clients "receive no benefit (promotional, special access, or otherwise) beyond education," a spokesman for the firm informed me. Yet when pressed, it became clear that only asset managers who pay to join the Institute—at an annual cost of $25,000 to $58,000—can attend the January conference. There, between workshops and panels and cocktails, they meet Callan’s asset-owner clients and, just as importantly, Callan consultants. Which raises the question: Do these significant financial relationships bias the firm’s recommendations in any way?
"As a practical matter, recommending managers in exchange for revenue is a direct violation of the Employee Retirement Income Security Act, and you can go to jail," Greg Allen, president and director of research at Callan, recently told me from the firm’s San Francisco headquarters. But Allen, who has been with the firm since 1988, readily acknowledged the possibility of unconscious biases. "If you’re in the consulting business for any length of time, you develop a list of favorite managers—you can’t help yourself. This happens across the business."
"What we do to manage that conflict is that every manager search we do is peer reviewed," he said. "The manager search committee gets together often. A consultant presents the entire search to the committee, and the committee has the opportunity to take shots. So very early on, if a consultant is coming through and bringing the same manager to every search, that gets ousted right way." Statistical evidence provided by Callan comparing their recommendations versus other consulting firms’ suggests that these controls are working.
The Callan Institute represents 11% of the company’s revenue: a minor but not meaningless figure. I wondered if they’d ever considered reforming the business model to avoid even a hint of impropriety.
"I can’t think of a time when we haven’t vetted the Institute," Allen said. "In 2003, the Securities and Exchange Commission looked at potential conflicts in consulting. Anyone who had a diversified model of any scale and worked with managers was looked at. They essentially gave the industry a clean bill of health, but it did focus people’s questions—they came up a lot. The Department of Labor did a follow-up exam, and that allowed it to linger. If there was ever a time to capitulate, that would have been the time. And we didn’t." The firm continues to look at the institute "every year," Allen said, but he and his colleagues "continue to believe it makes sense."
Asset owners don’t necessarily agree. One prominent corporate CIO, when I mentioned this arrangement, swiftly cut me off with a howl of surprise. The CIO was further surprised to learn that other firms—including Mercer and Segal Rogerscasey—are paid by asset managers in return for access to events. Mercer, for example, charges managers $35,000 to attend five events throughout the year through its Mercer Global Investment Forums. When asked how they managed such conflict, all three had a variation on NEPC’s earlier response: We have internal controls. Trust us.
Yet the practice of consultants receiving some form of compensation from asset managers is not universal. When I asked Tim McCusker whether NEPC accepts any payment from asset managers, his response was adamant: "Zero. None."
Ken Skarbeck is an asset management unicorn.
The founder of Indianapolis-based Aldebaran Capital, Skarbeck is willing to publicly say what others only whisper in private: That consultants have warped investment management.
He’s willing to say this because by his own admission, he’s had little luck navigating the consulting industry. "We’ve had a few instances where we’ve been invited to submit a request for proposal response—without success," he recently told me over the phone. He had previously emailed about an article in which Chief Investment Officer raised questions about Tampa Bay’s pension fund using only one long-only manager for its entire $2 billion portfolio. His problem, he wrote, was that we had failed to question the conventional wisdom that the consultant model of investing was valid. I wanted to know more.
"When we went through that process, they just wanted to put us in a slice of the pie," he said. "It is pie-chart investing. We find the whole process distasteful."
Critics will say that Skarbeck is simply voicing sour grapes—that his approximately $75 million fund isn’t institutional quality, and that if he was willing to invest the time to make it so he would see more success. He wouldn’t necessarily disagree with that.
"We do manage, along with one other manager, a stock portfolio for a community foundation here in Indianapolis. They have been shown the asset-allocation model, been told they can choose a consultant—and they’ve chosen to go the other way, and their performance has been better because of it." In essence, Skarbeck doesn’t want to play the game, he claimed. He’s happy to simply invest, a fan of the Benjamin Graham and David Dodd (and now Warren Buffett) school of thought.
“Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.” —Warren BuffettSkarbeck pointed to an unusual, and likely unsuspecting, culprit for the rise of the consulting industry: David Swensen, Yale University’s longtime investment chief.
"Going back a few decades, it was pretty much 60/40 for institutional money," he said. "It was pretty simple. The whole model changed based on the success of Yale. Others saw what they were doing and decided, ‘We need to copy that.’ So then your consultant industry sprung up and offered institutions a way to put those programs together."
Yale, of course, has done exceptionally well with Swensen’s model. "When everyone starts doing the same thing, it doesn’t work as well—you arbitrage away your performance," Skarbeck countered. "Yale was doing something outside the box, doing things others had not even attempted. They were getting some bargain deals. With the advent of the whole industry copying the Yale model, that ability to outperform kind of went away."
"The consulting model, where it goes wrong, has a lot of groupthink and rear-view mirror investing," he continued. "Take the credit crisis. You had things blowing up—nobody was going to be immune to that, and the goal is to lose less than everyone else. But coming out of that, every consultant was telling clients to be less allocated to stocks. ‘You need to be in low-volatility strategies and in tail-risk hedge funds,’ they said. The problem was that the event already happened. It’s like buying earthquake insurance after an earthquake."
Skarbeck is a realist. "To change the current institutional investment model would be like going to a flat tax and putting accountants out of work. It’s just not going to happen. They’ve got too big a hold on the industry."
While Skarbeck’s pessimism is quietly shared by many, his central thesis is loudly shared by at least one—and a very influential person at that. Warren Buffett, one of Skarbeck’s investing templates and a man of no small following, recently opined on the topic in his annual letter. "Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game," he wrote. "Most advisors... are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship."
Callan, NEPC, and every other consultant vehemently disagree with that sentiment, as will their clients. But after reading Buffett’s words and the rest of the interview transcripts for this article, I remembered a chance meeting in NEPC’s offices. In the waiting room, I had come across three gentlemen from a local asset management firm. They were there to speak to NEPC’s research team in hopes of eventually getting their strategy into the consultant’s lineup of approved managers.
It struck me: This asset manager had paid Chief Investment Officer substantial sums over the past year to attend our events and advertise in this magazine. While they may have had a previous relationship with the firm, these managers had met McCusker and other NEPC consultants at least one of our annual conferences—and McCusker had just recently watched this firm be recognized at our annual Industry Innovation Awards.
Conflicts, it seems, are truly everywhere. Just trust us.