At the time of the financial crisis, funds of hedge funds’ (FoHF) assets under management fell from around $800 billion in 2007 to $590 billion in 2008. It has barely recovered since: FoHFs managed $660 billion at the end of 2013, according to Hedge Fund Research, a data collator, that counts about 700 FoHFs that have simply disappeared. At the same time, investment consultants have muscled in and taken much of the industry’s business.
There is plenty of bad blood between investment consultants and fund managers as a result, but much of it bubbles beneath the surface. Tim Jenkinson, professor of finance at Oxford University’s Saïd Business School, recognises the difference between what fund managers say publicly and privately. “No-one underestimates the power of consultants,” he says, “No-one wants to say a bad word against them in public.”
It is a “well-known secret” that consultant recommendations earn funds millions of dollars, he says. But at the same time, consultants are competing directly against FoHFs, offering advice on hedge fund selection alongside other services at cheaper rates.
Funds argue that consultants are worse placed than FoHFs to find alpha: they do less due diligence, look into fewer funds and have less financial incentive for their underlying investments to perform well. Consultants argue that clients are attracted by factors other than performance: tailored advice, a wider range of advisory services and – in straitened times – lower fees.
Amid the war of words, who is right? Are pension funds better off investing in a FoHF, or can they simply hire an investment adviser?
Lack of transparency
The primary problem of analysing the value added by investment consultants is the sector’s lack of transparency. “The real problem here is it is a very opaque system,” says Jenkinson, who has endeavoured to chart the performance of consultants’ chosen funds. Consultants are usually unwilling to give academics insight into how good their advice has been in the past. What’s more, pension funds often sign nondisclosure agreements with their advisers, preventing them from opening their books to academics.
Jenkinson is eager to find out how well consultants really perform. “There is no public interest in keeping this [information] hidden,” he says. There is no commercial reason not to publish performance data, either, he thinks: pension funds should be able to find out a consultant’s performance record. The next step is for regulators to shine a light on the industry, he reckons.
The flurry of nondisclosure agreements is a concern, says Con Keating, head of research at BrightonRock, a London-based insurance group. Nondisclosure agreements make it impossible for clients to disclose costs, fees and even court settlements after clients have sued consultants. “My chief complaint,” says Keating, “is [consultants] do not publish their recommendations. They do not make available the data on which I can judge whether they are any good at what they claim to be doing. Consultants have a privileged position in law and they are abusing it by not publishing the data.”
Jenkinson has experienced challenges extracting data from consultants in order to publish research, but did manage to collect enough to publish “Picking Winners? Investment Consultants’ Recommendations of Fund Managers” (2015 , Journal of Finance). In it he found no evidence that consultants’ recommendations of US equity funds between 1999 and 2011 added value.
On an equally weighted basis, funds recommended by consultants during the period underperformed by 1.12% per year, compared with funds not recommended. The paper found that there was a tendency to recommend large funds, which perform worse. “There could also, of course, be a simple lack of skill,” the paper says.
The tendency to pick the biggest funds for pension fund clients is a common complaint among small or boutique hedge funds. “We focus on the biggest, most established managers,” says Alison Clark, head of hedge fund research at Hymans Robertson, a pension consultant in London. “We’re not trying to find the new, next best manager. We don’t need to cover the entire universe of hedge fund managers.” She sees her role as tailoring hedge fund investments to pension clients’ needs.
The first thing she does as a consultant is to find which strategy suits the client: long/short equity might not suit those who want a lower equity exposure, for instance. Once the strategy is determined, she puts together a shortlist of fund suggestions. For distressed debt, for example, she admits Hymans Robertson looks at the profiles of “about 10” established hedge funds. “I think it would be difficult for any consultant to argue that they have better resources to identify managers than the big established funds of funds,” Clark says.
Barriers for small funds
As institutional investors grow in influence, consultants will increasingly act as gatekeepers to capital inflows. Small hedge funds worry about not being on the list of recommended funds: size matters, they say. Policy-makers, meanwhile, have started fretting about capital flowing to the same big funds, as consultants have more sway.
The consultancy Mercer looks at a total universe of 3,000 to 4,000 managers, but Robert Howie, European head of the alternatives boutique, says there are less than 100 that the firm “rates highly”. This means, for example, that there are between five to 10 distressed debt funds that Mercer would recommend. The company says there is no minimum size or minimum track record, and Mercer employs about 20 hedge fund researchers to monitor its database of funds.
FoHFs say that they select from a wider pool of fund managers. Some, including US-based Benchmark Plus and Lighthouse, say there are high returns to be made from small or boutique funds. Nonetheless, data from research company eVestment shows over the past three years, the number of underlying funds that FoHFs invest in has diminished. At the same time the typical underlying fund has grown in assets.
Another complaint is that, as well as monitoring fewer hedge funds, pension consultants perform less due diligence on those funds. “Few consultants have met with us,” says one hedge fund manager. “The funds of hedge funds are much more proactive.”
Edward Vickery, US-based owner of Caradon Capital Introductions, , says he knew one consultant who would avoid meeting portfolio managers because it would cost him money. “Funds of hedge funds have records on every manager. They are excited to meet a new one,” he says. “You don’t get that with many consultants, even the bigger ones.”
BrightonRock’s Keating, who has had a long career in the pensions industry, says the due diligence conducted by consultants is often poor. He says he has a trick, where he asks consultants to tell him one or two of their favourite managers. He then asks them the colour of the wallpaper in their offices. “No-one has ever been able to answer that question,” he says mischievously, as consultants rarely go to their managers’ offices. He adds on a more serious note: “You can’t expect the consultants to do the same amount of work [as FoHFs]. There are some [consultants] who have very good research departments, but there are an awful lot whose research is cursory.”
The heart of the problem, says Vickery, is that consultants are not financially incentivised to pick high-performing funds. “Funds of hedge funds are incentivised to perform well,” he says, hence the drive to do more due diligence, correlation analyses and develop relationships. Their pay rises with higher portfolio returns.
Bijesh Amin, New York-based managing director at Indus Valley Partners, a technology services provider, says the key difference is that pension consultants and FoHFs move in very different circles. Consultants tend to have a background in accountancy and actuarial science, while most executives at FoHFs have worked in the same industries as the fund managers they select. They therefore tend to have better relationships with the fund managers, having followed their careers.
Defenders of consultants say this is a factor in their favour. Consultants can recommend portfolio managers based on an impartial analysis of the numbers, rather than connections. They are therefore free from conflicts of interest arising from allocating capital to friends or former colleagues. Conversely, however, Oxford University’s Jenkinson believes consultants are not free from conflicts of interest and that may explain the underperformance of their fund selections. He hopes to look into this, once there is more data to hand.
The last complaint is that investment consultants may cause a kind of ‘group-think’ in investment markets. The Law Commission, an independent body that reviews law reform in England and Wales, in July urged regulators to “actively monitor” consultants. It said that herding behaviour could result from pension funds receiving similar advice, a matter that had implications for financial stability.
“Consulting advice is all very similar,” says Keating. “What that tends to do is to a certain extent make [advice] a self-fulfilling prophecy.” If Towers Watson, Mercer and others tell pension funds to invest in corporate bonds, their worth will rise. Keating calls this effect the “market for lemmings”.
Consultants take advantage of the fact that pension funds know very little about the hedge fund industry, Vickery says. Hymans Robertson’s Clark admits knowledge of hedge funds among many pension fund clients is “quite limited”.
“Typically they don’t have the internal resources to monitor funds,” she says, so they delegate.
One hitch is that consultants tend to give overly short-term investment advice, according to a review of UK local government pension schemes conducted by Clerus, a research company. The 2014 report suggests that “each consultant ends up recommending a similar list of managers who are ‘popular’ at any given point in time”. Certain managers were recommended “almost universally” during this period.
Some investment consultants benefit directly from new managers being selected. Consultants can earn additional brokerage from terminating managers and funding new managers, and some charge manager search fees in addition to annual retainers. In this case, there is a bias in favour of short-term portfolio change. This negatively affects portfolio performance, according to the review, with returns dropping by 0.5% per annum. “The total cost of this short-termism can be valued at £740 million per annum… across all local government pension schemes,” the report says.
Jenkinson concludes in “Picking Winners” that underperformance is driven by additional but unnecessary costs incurred by pension funds to suit the revenue models of consultants, combined with a lack of demonstrable skill in selecting managers or providing asset allocation advice suitable for the long term.
Why so popular?
If investment consultants add little in terms of returns to pension funds’ portfolios, as Jenkinson suggests, then what explains their gaining sway over the past few years? Why are pension funds increasingly opting to cut out funds of funds and accept consultants’ advice on hedge fund investments? A Towers Watson spokesman says: “There are good reasons why large investors have been moving away from most FoHFs and it is not because consultants are telling them to. They’ve worked it out for themselves. Fees are still too high, funds are excessively complex and lack transparency [and] contain too much beta.”
Keating says another advantage of consultants is that they are, sometimes literally, already in the building. Regulations require pension plans to appoint an investment adviser of some sort. “I think I would be inclined, based on recent performances, to appoint my cat,” scoffs Keating. “But that might run counter to some European legislation.”
Bradley Ziff, New York-based senior risk adviser at risk management software provider Misys, says that after the 2008 financial crisis, pension funds fundamentally changed the ways they operated. Many reviewed their allocation process and recognised the need for greater board and senior management involvement. They carefully scrutinised the risk/return profiles of their investments, and many decided to interact in a more direct way with the alternative sector, which improved their relationships and in many cases reduced allocations to FoHFs.
In all this, consultants were and are a “one-way challenge” to FoHFs, says Ziff. Large consultants such as Aksia Albourne, Cambridge Associates and Mercer argued that they had equal access to funds, similar or stronger expertise in the selection process, and robust due diligence and risk operations. When performance by FoHFs dropped off, their big appeal subsided. On that score, says Ziff, 2008 did irrevocable damage to some of the participants in the market.
In addition, consultants advise pension funds on their whole portfolio. Hymans Robertson advises pension schemes on other alternative investments, such as real estate and private equity. FoHFs traditionally offer a narrower base of advice. Appointing advisers is also a useful way for pension funds to pass responsibility. “Pension funds like the idea of bringing in a third party and demonstrating some independence in their own processes,” says Ziff.
FoHFs fight back
Canny FoHFs have reacted by offering more in terms of transparency, flexibility and tailoring to clients’ needs. “The landscape has really changed,” says Scott Perkins, Florida-based executive managing director at Lighthouse Investment Partners. “We’ve shifted the business model from a set of fund products to a solutions business, and that’s a function of how consultants work with their clients.”
Almost all of Lighthouse’s hedge fund investments are structured through its proprietary managed account program. At the time of the 2008 financial crisis, the FoHF had already converted many of its investments into managed accounts. Perkins says of Lighthouse’s value proposition: “We put our resources into knowing a narrow part of the market, knowing the players in the market, knowing where they have moved over time,” he says, “and our clients value that as a part of our overall solution.”
Chicago-based FoHF Aurora Investment Management offers accelerated capital to new fund managers, which it claims differentiates its offering from consultants. Scott Schweighauser, president and portfolio manager at Aurora, says it is much harder nowadays to launch a hedge fund. Aurora effectively offers seed capital, underwrites new funds, helps negotiate lower fees and gets capacity rights. “Those pension fund consultants are not in the position to do that, so that is a true value-added proposition,” says Schweighauser.
Schweighauser looks at his job in terms of solving specific investment needs in clients’ portfolios. “This is another step in the evolution of greater engagement between manager and client,” he says. Transparency is no longer shunned in the industry, he says. Aurora offers a complete portfolio analysis, including advice on alternatives and ongoing risk management services.
How do FoHFs see the rise of the consultant in their space? Schweighauser says: “It is an opportunity for us to prove our worth. Ultimately the big winner is the customer.” Lighthouse’s Perkins is similarly upbeat. “Healthy competition is good. It means we have to continue to up our game,” he says.
Nonetheless, Tim Jenkinson of Saïd Business School reckons that consultants’ growing influence must rankle, especially as they have previously conducted due diligence on those same FoHFs. “I’m not sure I’d want them coming in, seeing the secret sauce and then going on to take business from them,” he says.
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