• Brian Schroeder

Maybe It's Your Structure?

Every investment consulting firm I have reviewed has competent, smart and credentialed professionals with advanced degrees. They have manager search departments, perform deep analysis and create proprietary models to help clients meet their investment objectives. In performing their duties, most are hampered by client structures that tie their hands resulting in average returns.

When analyzing long-term universe rankings, there are plans at the top, bottom and in the middle. Following statistics, when the universe is sufficiently large and representative, there will be a normal distribution or Bell Curve. At the tails are plans that did extraordinarily well and extraordinarily bad. Most simply fall in the middle, just average.

Some plans occasionally have superior stretches of good and bad performance bringing them into and out of the tails. Few are consistently good. Most, however, are habitually stuck at average. If this describes your plan’s investment returns, here are the 3 reasons why your investment structure may be the cause.

You will also find simple solutions to improve your structure for better performance, governance and monitoring.

Structured to be Average

Most institutional plans follow a top-down, bureaucratic structure. At the top is the plan sponsor or board of trustees. In the middle is normally a non-discretionary investment consultant. At the bottom are investment managers following defined mandates in various asset classes.

Guiding the overall process is an Investment Policy Statement to achieve a stated objective. It covers asset allocation, rebalancing, manager selection, governance, etc. Normally, the IPS is crafted by the investment consultant who then oversees implementation. The plan sponsor then votes to approve/deny recommendations and monitor the consultant.

There are two fatal flaws with this structure: lack of critical monitoring and lack of strategic diversification.

This consultant-centric model concentrates and bottlenecks at the investment consultant who provides the performance reports. Your investment consultant faces many conflicts of interest in their duties and self-reporting. Read How Conflicted is Your Investment Consultant? to learn how they are conflicted in every facet of their duties. Further, there are many tricks and gimmicks they use in their performance reports that mask their true value-add. Read the Field Guide to Overcoming Investment Consultant Conflicts of Interest to incorporate meaningful monitoring.

If you follow the advice of a lone investment consultant, by definition, you have no strategic diversification. You are putting all your strategic eggs into a single basket. If your plan’s historic universe rankings are average, you may indeed have an average investment consultant. Why they may deliver average results will be discussed further below.

Here are a few solutions to bring strategic diversification and dynamism to your structure. First, hire another investment consultant and give them assets to manage. Second, instead of hiring another consultant, hire a multi-asset class manager. Third, hire an Outsourced Chief Investment Officer (OCIOs) even for just a small % of your AUM. Each of these strategies will diversify strategic thinking, diversify investment consultant risk and create a comparative environment where more than a single opinion will be represented at board meetings.

Defendable & Delayed Decisions

In the consultant-centric structure, decisions are delayed and often follow a “defendable mindset.” Decisions are usually made at the speed periodic meetings. Sometimes these decisions are first discussed and vetted at sub-committee meetings creating more delays. The consequences of delayed decisions are not seen or felt. But sometimes, especially when investment products are queued for entry and exit, delays can sometimes be costly.

Delays can often be seen in the hiring and firing of investment managers. When firing, there is often the watch list. Poor performing managers often go through a process of being put on watch, watched, then interviewed, and if things haven’t turned around, they are fired. Similarly, delays with hiring can also be a problem. Plan sponsors need to calculate the opportunity cost of delays.

Defendable decision making is not defensive decision making. It means only making decisions that you can defend later to a contributor, participant or in court. In my 10 years of helping plan sponsors perform due diligence on their investment consultant and process, this is perhaps one of the costliest problems following the consultant-centric model.

When performing due diligence for plan sponsors, I examine the recommendations seeking behavioral finance patterns. Time and again, investment consultants present defendable decisions for approval. They recommend managers that are top performers and propose new asset allocations that have a higher expected return and risk. Rarely do they propose firing a hot manager, hiring a cold manager or propose an asset allocation with a lower expected return. These recommendations can be easily defended by both them and the client.

This pattern makes perfect sense. Why would an investment consultant ask a client to hire a poorly performing manager hoping for a bounce back while risking continued poor performance? It is much easier to defend saying, “We hired the best manager in the asset class.” Investment consultants do not want to bring hard recommendations to a vote. Nor do trustees want to be faced with tough choices that may expose them to criticism or potential removal from office.

The only way to remove the delays and defendable decision making is to either delegate to an OCIO or multiple OCIOs, or multiple, multi-asset class managers. How Many OCIOs Should You Hire? discusses these strategies in detail.

Total Risk Conflict of Interest

Investment consultants want to continue to stay hired by delivering quality service resulting in superior returns. How many investment consultants would get hired promising average returns? Plan sponsors need to be aware there is a total plan risk conflict that every investment consultant and OCIO confronts.

Investment consultants can either step on the gas seeking higher returns or pump the brakes to lower risk and potentially lower returns. Of course, when to do these two things depends on their outlook, or does it? Rarely does a consultant get fired for playing it safe. The matrix below explains this conflict perfectly. In other words, are investment consultants protecting their jobs at the expense of missed return potential? After all, missed opportunity is neither seen nor felt by the client and difficult to quantify.

Print & Discuss This at Your Next Meeting

The solution is simple. Create a competitive/comparative environment by hiring another investment consultant, multi-asset class manager or OCIO. You will be able to compare strategies, debate outlooks and analyze return attribution instead of the echo chamber from a lone source of opinion.

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