In the field of Public Choice Economics is the study of Empire Building. In a nutshell, within the public sphere, politicians and bureaucrats have strong incentives to "build their empires" with wider controls, larger staffs, bigger budgets and greater influence. The intended result is higher pay, increased job security and more benefits; often at the expense of taxpayers and civil liberties.
The Covid-19 crisis explains perfectly Rahm Emanuel's famous quote. Bureaucracies such as the CDC and state/county health agencies have expanded their empires with increased power, larger budgets, bigger staffs and greater job security while the citizenry has lost freedom and wealth.
In the world of institutional investing, one can see similarities in how investment consultants behave managing their "crisis" to continually perform. Let us review some history and explore how investment consultants empire build to increase their fees, expand control and ensure job security at the expense of client performance.
A Brief History of Investment Consultants
The modern investment consulting industry is not even 50 years old. Rising out of the ashes of deregulation of brokerage commissions, known in the industry as "May Day" (5/1/1975,) many stock brokers adapted and became investment consultants to fill the pay cut. Prior to this change, banks' trust departments, insurance companies and money managers served institutional asset owners directly without investment consultants.
These new entrants inserted themselves as intermediaries by bringing greater client involvement through tools such as asset allocation studies, manager searches and third-party performance reporting. They claimed independence and objectivity by not being limited to in-house products. Best of all, they worked for "free;" so long as enough of their client's brokerage trading went through their affiliated brokerage.
Over time, clients and government regulators caught up by forcing these investment consultants to become fiduciaries while reducing conflicts of interest from directed brokerage and commission recapture schemes. Today, these investment consultants are primarily fee-only providers, named fiduciaries and mostly unaffiliated with brokers.
Despite this evolution, investment consultants still find ways to empire build to fortify their position. Let us examine how they do it so that institutional asset owners can better manage their investment consultants should there be evidence of empire building tendencies.
More Managers + More Asset Classes + More Complexity = Higher Returns?
Without fail, every due diligence study I have performed saw more of everything. The investment consultant brought on more managers and more asset classes creating more complexity. Of course, this required more meetings and created more fees. Let me share a few real world examples that demonstrate the point.
One investment consultant began diversifying a balanced manager's portfolio after that manager's five-year performance fell below median. The client's portfolio ballooned from 1 balanced manager to over 15 specialty managers. The investment consultant's work load and importance increased, manager fees went up due to smaller mandates, and performance suffered due to chasing hot managers. Soon after, the investment consultant asked for a fee increase. When asked why the fee increase was warranted, the investment consultant answered, "There are now more managers to monitor."
In one study the investment consultant was constantly tinkering with asset allocation. Not only were they adding new asset classes, they were also frequently changing the weightings. The client saw that they were always "doing something" following the advice of this Top-10 (by AUM as of 12/31/2020) investment consultant. Unfortunately, it turned out if they had made no changes they would have had over 5,800 basis points of additional performance during the investment consultant's tenure. But they were always doing something!
Things like cars and the US Tax Code have become so complex, that highly skilled professionals are needed even for routine matters. Investing has also become too complex thus necessitating highly skilled and educated investment professionals commanding high fees. Or is this a myth that helps investment consultants stay employed?
The "60/40" destroys the myth that greater complexity and expert advice is needed for superior performance. This "lazy portfolio" only requires two index funds and quarterly rebalancing. It has handily beat a super-majority of active and complex approaches that reward investment consultants with job security and high fees. Ask your investment consultant to report how this simple model's returns rank in your universe.
Active Management vs. Passive Management
Anecdotally, I have never been asked to perform investment consultant due diligence for a client that uses only index funds for public market asset classes. Academic studies have routinely concluded that institutional investors have great difficulty successfully hiring and firing active investment managers. They often chase returns by hiring hot managers and then fire after a cold streak; thus ensuring below-benchmark performance.
For several studies I have performed, investment managers' relative performance was better after termination than while they were hired. In other words, the investment consultant was buying high and selling low. The graph above depicts this common pattern perfectly.
Despite the academic and anecdotal evidence, investment consultants continue to use active managers for the empire building benefits. Let us explore how employing active managers benefits the investment consultant.
First, as was noted earlier, the use of active managers requires continuous monitoring. The more active managers means more monitoring work, manager due diligence and performing searches. With active managers, there is always something to talk about or potentially do, thus increasing the need for an investment consultant. With indexing, such extra duties are eliminated and fees are substantially lower.
Second, with a sufficient number of active managers, there will always be some that are under-performing and "on watch." This serves investment consultants well during times of client unhappiness. It is no coincidence in my studies that there are more firings of active managers following market turmoil as it is a great deflection for poor total plan performance by blaming then firing poorly performing active managers.
Third, active managers charge active fees that are many multiples of index funds. Active managers then use these fees to lobby investment consultants for business. Investment consultants (and clients) can leverage their Gatekeeper role with perks such as tickets to sporting events, supporting their charities, subsidizing attendance at conferences and fancy dinners around client meetings.
Finally, some investment consultants host conferences which active managers pay to attend and sponsor. On top of that the active managers coordinate affiliated events including golf, sightseeing tours and dinners for both the investment consultant and attending clients. I have reviewed reports for investment consultants that host such conferences, and not surprisingly, a large number of those active managers are used in client portfolios. Are these active managers being chosen for their sponsorship? Even though it is disclosed, "pay to play" still exists despite the legal and fiduciary safeguards.
Too Big to Perform?
Investment managers on a hot streak sometimes close their doors to new clients because more and more assets can drag down performance. They do this to protect their existing clients and their track record. This is more often the case for niche managers in smaller markets like small cap equity or high yield bonds as opposed to U.S. large cap equity or international investments.
But never have I heard of an investment consultant closing their doors to new clients despite the very real problems of over-capacity. There are three glaring areas where an investment consultant is forced to choose between clients, sacrifice conviction or lose nimbleness due to over-capacity. The three areas concern manager selection, rebalancing and illiquid investments.
To illustrate these critical issues let's suppose an investment consultant has $500 billion under advisement for 500 pension fund clients that have nearly the same objective. Therefore the average client size is $1 billion. Let us also suppose the investment consultant is a fiduciary to each client and gives all clients equal preference.
Now let us say this investment consultant has a market-like allocation to U.S. small cap stocks of 7.5% and believes in can effectively select active management. This means the investment consultant must place $37.5 billion with an active small cap manager. From a trading and market-impact perspective, a single active manager in small cap stocks cannot effectively manage such a large portfolio. Due to the sheer size, the investment consultant is forced to make a choice.
The investment consultant can put all of the $37.5B into the one small cap manager, or it can spread those assets into lower conviction managers equally among its clients. If the investment consultant chooses to violate equal preference, it may choose to allocate assignments among its clients in an unequal manner so that some clients have a lower-conviction manager. How are clients to know if they have a lower conviction manager? Regardless of how the investment consultant manages the issue, their sheer size will tend to lower client returns when using active managers.
Rebalancing is the next duty impacted by an investment consultant's size. Can this investment consultant still be nimble with 500 clients and $500 billion under advisement? Just look at the volatility we have seen over the last few years. Again, the investment consultant cannot effectively move within the markets while treating its clients equally.
These two problems of manager selection and rebalancing are amplified when it comes to illiquid and quarterly-valued alternatives. Let us say this same investment consultant invests in quarterly-valued real estate and their clients have a 10% allocation. That would be $50 billion with a single manager. Of course, like the small cap problem, the investment consultant would likely need to include lower conviction managers for liquidity.
Near the end of 2018 I advocated institutional investors trim to the lower-end of their real estate allocation. In this hypothetical, that would mean liquidating approximately $15 billion in real estate in less than 60 days. There is no way this highly profitable move could have been executed by this investment consultant for all of its clients given its large AUM. Either it would have to forgo the opportunity, or give certain clients preferential treatment.
Finally, this investment consultant will have great difficulty in exiting or funding illiquid strategies in an equitable manner. For all practical purposes, their clients will collectively be stuck with managers they are slowly exiting and not fully enjoying the managers they are slowly funding.
To OCIO, or not to OCIO? That is the question.
Many investment consultants now serve as an OCIO, Outsourced Chief Investment Officer. I strongly agree that an OCIO can perform better than a non-discretionary structure. This comes with a large pay increase and is actually less work than a non-discretionary client. After all, they don't have to educate clients hoping they vote to approve the change at their next meeting as the OCIO now has discretionary authority.
If some of the investment consultant's clients do not convert to their fully discretionary OCIO service, they are disadvantaged and actually help the OCIO clients. The clients that choose OCIO have the advantage of speed of execution and their portfolios are adjusted first. The non-discretionary clients are moving at the speed of meetings and thus act subsequently and propel the OCIO clients that are front-running the portfolio changes.
If an investment consultant has both non-discretionary and OCIO clients, and they serve as a fiduciary to both, they are empire building at the expense of their non-OCIO clients by making them second-tier clients. The ethical decision would be to convert every client to OCIO. If the client refuses, the investment consultant should resign from the client.
What Should Clients Do?
Institutional asset owners are now aware of empire building and how their performance can be negatively impacted. They must evaluate their specific history and address the issues raised in this article as they pertain to their investment consultant.
Depending on the outcome of your discussion, please consider OCIO Monitor for an independent review of your investment consultant's or OCIO's value-add in achieving your investment goals.
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