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A question of benchmarks

Advice on investments is in greater demand than ever. The consensus that equity markets will deliver sober returns in the decade ahead is forcing investors to consider alternatives, with implications for them and their advisers.
Indeed, Bill Muyskens, Mercer Investment Consulting’s head of global research, says alternatives are the final stage in the process for pension funds transforming their investment structures from balanced to specialist.
In 2004 Mercer conducted 22 currency management searches and 12 fund of hedge fund searches. These were the two most popular categories across all asset classes, including bonds and equities.
Property holdings, venture capital, private equity and hedge funds are all more opaque than publicly-registered securities. Most are less liquid. Few offer the enquirer satisfactory relative data.
All of which should spell a bonanza for those consultants which have the resources to separate the wheat from the chaff and offer insightful advice.
There is evidence that investors considering alternatives are not making fees a deciding factor. In some fund of hedge funds search longlists, for example, fees have no weighting. Quantitative sifting is based exclusively on risk and return data.
In spite of this trend, it still seems odd that consultants are being asked to analyse rarer, more complex and sometimes obscure investment strategies without a corresponding rise in fees. Even if fees are not a major part of the longlist process, hedge funds and private equity players charge a lot: most have performance incentives which mean total charges of 2% are not uncommon.
Consultants, on the other hand, are still seldom measured by quantitative means while performance-related fees, suggested by Watson Wyatt in the wake of the Myners Report, have not taken root.
Instead, relationships and reputation, even in an industry apparently driven by analysis of data, remain paramount. “Reputation is 90% of your business,” remarks Tony Osborn-Barker, a director at Deloitte Total Rewards and Benefits. For example, when a major €2bn UK scheme reviewed its consultants in 2003, it held a beauty parade.
“We put together a pretty generic questionnaire then allowed each one to present and give their view of the markets,” recalls the pensions manager, who asked to remain anonymous.
There was, however, no real quantitative testing of the consultants’ abilities or track record.
Significantly, the pensions manager relates that the brief was reviewed in part because of disagreements between some of the trustees and the incumbent adviser on market views.
The incumbent was, of course, invited to retender and failed. The anecdote exemplifies that however unquantitative and “fuzzy” they may be, feelings make a difference. If the rapport between client and adviser becomes strained, facts are used to justify different viewpoints rather than being the bricks with which to build a consensus.

Watson Wyatt’s European investment consultancy, which has approximately 50 of the top 100 UK pension funds as clients, and about one-third of the UK FTSE-100 as pension fund sponsor clients, has succeeded in averting conflict and avoiding much strain. Many of these relationships stretch back over decades, and while the firm has made awkward decisions, such as exiting the UK local authority market, it is content to rest its business on the relationship model.
“We like to be in the role of trusted adviser,” says Nick Watts, head of European investment consulting. He sees Watson’s remit as helping the client meet its liabilities and emphasises the strategic nature of advice.
The respect among investment bankers for the likes of Nick Horsfall, who works with Watson’s clients on liability-matching strategies including structured products, is evidence of the remit well-exercised.
Beneath the strategic level, Watson has been running model portfolios to demonstrate the efficacy of its manager advice. But Watts does not see this as a precursor of manager-of-manager activity. “I would say that manager selection is the least important thing we do,” he remarks.
For successful managers of managers, this may be a welcome statement by a potential competitor. But it is sound business practice by Watsons. Ten years ago all the talk was of the switch to defined contribution. Pension scheme consultants would need only be glorified fund-pickers. Liabilities would transfer to the individual scheme member and the actuarial profession’s numbers would diminish.

In 2005, the long life of liabilities and their impact on sponsors’ balance sheets is the headache for many European corporates. Electricity giant E.ON UK announced in January a one-off contribution of £420m (e610m) into its main pension scheme. The importance of defined contribution remains something for the future while consultants with a knowledge of liability-matching are in demand now.
Pricing structured products is itself so sensitive that few clients are able to evaluate quantitatively the adviser’s work. Pension funds and investment banks are not that familiar with each other and there is much for funds to do to understand how banks operate. In the sophisticated new world of precise liability-matching, trust and relationships are again pre-eminent.
This ethos would suit the firm’s European practices, such as PPC Metrics, which has a strong understanding of liabilities. But for those consultancies that have developed a manager-of-manager division, quantitative measures are far clearer. “As a manager of managers we are absolutely accountable,” says Jon Baillie, Russell Investment’s managing director for institutional investment services, EMEA.
He adds that Russell believes manager of managers is a solution suitable for all pension funds, and fits Myners’ ethos that if trustees do not feel sufficiently able to make investment decisions, they ought to appoint a body which can.
Since the third quarter of 1999, a healthy ratio of Russell’s manager-of-manager funds have been above average, with few in the bottom quartile.
Other consultancies are prepared to subject themselves to quantitative measures.
John Conroy, a principal at PSolve in London, says that its manager recommendations are externally verified by HSBC. He believes this puts PSolve “well ahead of the game” in terms of transparency. Clients can see how the managers selected by PSolve have performed.
Unlike Russell or SEI, PSolve does not position itself as a manager of managers. Its institutional clients tend to be defined benefit plans and its manager selections form part of a wider service relating to strategy.
If quantitative measurement of managers of managers is relatively simple, consultancies which wrap asset management and liabilities can prove more difficult to evaluate. Unless there is a clear contract delegating responsibility for asset management selection to the asset manager, attribution of decision-making to consultant and trustee board becomes awkward.
Put another way, how many external consultants propose a single manager, without a beauty parade? Whatever one’s views on the efficacy of shortlists, to abolish them would signal the redundancy of the trustee board in manager selection.
It is worth noting that there are in-house investment teams at pension funds who feel confident enough to suggest single managers, sometimes with a policy that if the board does not accept them, no allocation to that manager’s speciality or asset class will be made.
This confidence is perhaps never to extend to consultancies. “I’ve yet to see a consultant issue a public sell recommendation,” remarks Osborn-Barker of Deloitte’s.
His point is that consultants have made a fair living informing trustees of events in progress months before action is taken. Each letter explaining what is happening at relevant asset management houses is added to the quarterly bill. He claims this ignores the dynamism required for the sake of the fund’s assets when major events occur.
Perhaps the growth of managers of managers addresses this need for responsiveness. It will not address the more complicated matter of quantifying strategic advice. Watts is right to tone down the significance of manager selection. If returns are mostly explained in terms of asset allocation, how would a client in hindsight determine the accuracy of advice given here? The Morris Review of the actuarial profession in the UK might have criticised the role of actuaries in investment matters in its interim report, but few market practitioners are joining the fray. This is because since balanced management passed out of fashion, few are competing for business at this level.
But if one type of measurement of consultants’ advice is truly needed by institutional investors, it is at the level of strategic allocation.

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