Moving out of the comfort zone
Once upon a time there were clear demarcation lines in the financial services industry. Accountants, actuaries, asset managers and pension fund consultants all kept to their strict disciplines.
However, over the years financial pressures have pushed specialist firms into offering services once alien to their own core businesses. And one of the trends has been for pension fund consultants to expand into other areas.
In particular, some companies have now become involved in sharing in the investment outcomes of their clients' strategies by offering multi-manager services.
"There is certainly a growth in multi-manager and implemented consulting, with investment consultants suggesting that the best way to look after clients' assets in future may be to effectively act as their fund managers," says Chris Edge, chief executive, EPIC Investment Advisers, which provides expert independent investment advisers to pension scheme trustee boards. EPIC also carries out some fund manager search and selection activities.
"In the past 20 years, there has been a trend among the big US consultancy firms such as SEI and Frank Russell to move from consultancy towards multi-manager operations," he says. "Russell still provides investment consultancy, but only for very large schemes. Now other traditional consultants like Mercer have begun to enter the multi-manager arena."
Edge says the core pressure behind this shift is what he calls the "perfect storm" for pension funds, ie a combination of various negative factors.
"First, the funds were all heavily invested in equities which halved in value between 2000 and 2003," he says. "At the same time, inflation and interest rates went down and bond yields fell to 5%, which meant liabilities rose." Edge points out that pension funds have also been hit by improved longevity assumptions, and increased regulation.
"The fiduciary responsibilities of trustees have gone up astronomically," he says. "It's a bleak picture."
He also says another dynamic is the change since the rising stock markets of the 1980s and 1990s, when consultants used to put clients into balanced funds with, in reality, only half-a-dozen major global asset management firms. Because of the small number of recommended companies, consultants did not have to spend much money on research.
"Today, however, we are in a low-risk, low-return environment and pension funds have to make every penny of their scheme assets work," says Edge.
"There are many more sophisticated investment techniques around, such as hedge funds and private equity, with as many as 10,000 different fund managers worldwide. So in order to be credible, ‘waterfront' consultants have to demonstrate their research capability, and the cost of research has gone up enormously. If pension schemes leave their investment decisions to consultants, the consultants can charge significantly higher fees for the asset management."
However he notes: "When investment consultants set up a fund management company there is an inevitably a potential conflict of interest."
"The transition from pure consultancy to asset management is still at a fairly early stage, but is gaining more momentum among small to mid-sized pension schemes," says David Hunter, director at Valiance, a niche pension scheme funding and investment solutions provider. "The attractions of using a one-stop adviser/provider are greater for smaller schemes, since investment matters would otherwise often take up a disproportionately large amount of trustees' time."
But Hunter agrees that where consultants take on this additional role, there is a real conflict of interest.
"There are often some difficulties with this perception among clients who have appointed investment consultants to provide independent advice on fund management appointments," he says. "A multi-manager effectively subsumes that role into its own fund offering. They take the decision to hire and fire sub-manager firms, and so a related-company consultancy might find itself suggesting that clients consider the multi-manager funds which their organisation provides. So in this environment, clients need to be sure they are either being given a truly independent choice of offerings, or the benefits and risks of any related-company recommendation are disclosed and clearly understood, ie the conflict must be demonstrably properly managed."
Having begun life as a brokerage firm in 1936, Frank Russell made the transition to managing managers in 1969. Seeking to identify the world's best individual investment managers for institutional clients, the firm grew into a manager research and strategic advice business, offering both ‘traditional' consulting and manager research and selection.
In 1980 Russell set up its multi-manager service, through which small and medium-sized schemes could amalgamate their funds in pooled arrangements, enabling them to diversify between different managers and styles.
"But for clients, having more than one manager in the portfolio means that costs can go up," says Johan Cras, Russell's managing director, institutional investment services, Europe, Middle East and Africa. "So the third leg of our offering is our implementation business, helping clients with the execution of their investment management structure, for example ensuring efficient manager transitions." Cras agrees that there has been a blurring of the boundaries between disciplines which were formerly separate.
"Until about five years ago, consultants kept to their traditional space," he says. "But with pensions challenges becoming harder, some traditional consultants, investment banks and multi-managers are becoming closer in terms of their operations, and we are all now trying to capture integrated solutions for clients."
Cras argues that what distinguishes Russell from competitors is its long experience in implementation.
"We have had 25 years where we've made mistakes which we've learned from, while other firms haven't yet amassed this level of experience," he says. "Furthermore, not a single penny of clients' money is managed by our company. So unlike other multi-manager companies, we don't have to make a decision as to whether to run money within our fixed-income team rather than outsource it to a third party."
He adds: "We don't have an investment bank or insurance capability. So if we don't implement the multi-manager side well, there's no Russell."
bfinance is a consultancy whose only business is providing fund manager review and selection to institutional investors. Clients pay nothing, but the winning fund manager pays a success fee based on the type and size of the mandate awarded.
"Our model has benefits for both the managers and clients because it is such a fragmented market," says David Vafai, chief executive officer of bfinance. "Globally, there are thousands of managers. Our clients benefit from being able to comprehensively scan the whole market and our model tends to be seen by the managers as a cheap way of accessing new business."
Vafai says that several factors have brought about the existence of his company. "First, as a result of the ‘perfect storm' of simultaneously ballooning liabilities, the equity market downturn of the early part of this decade and corporate scandals, there has been a much greater emphasis on proper governance, and in particular in the pensions area and therefore on the need for independent and transparent decision making.
Second, pension funds are looking for broader diversification of their assets. Driven by this demand for diversification, the number of managers has multiplied over the years, making the need for a wider search process necessary."
Third, factors like the Myners report and EU public procurement rules have also highlighted the strengths of the bfinance approach, says Vafai.
He says that one of bfinance's strengths is its independence: "We only provide fund manager selection, not asset management or ‘implemented' consulting or advice to fund managers, so we have no conflict of interest when making recommendations."
"It is true that the borders are blurring between investment consultants, managers and investment banks," says Dirk Söhnholz, managing partner, Feri Institutional Advisors in Germany. "But I think it's a good thing because the more choice the client has, the better. However, what is required is transparency about the fee structure, and about conflict of interest. So pension schemes should be aware of that and ask for information on those issues. For instance, investment banks get more fee income so they can hire expensive people who may be better than traditional consultants."
However, Söhnholz does not consider that all pension funds are sufficiently aware of conflicts of interest.
"In Germany, there is a lot of talk, but not enough thinking through," he says. "There is a significant bias towards traditional consultancy models, but when the banks offer consulting services we don't hear clients talking about conflicts of interest. Some of our own clients say they don't want performance-based fees, but I haven't seen any clients of investment banks wanting to discuss that."
"Multi-manager and fiduciary management are not entirely the same," says Erik van Dijk, chief investment officer and partner, Compendeon pension and investment consultancy, based in the Netherlands.
Compendeon operates two units - one dealing with corporate governance, the other with asset management. "Fiduciary asset management tends to have a more long-term relationship with the pension plan," says Van Dijk. "Managers put their money where their mouth is and there's a much stronger performance-related component. They also get involved with all kinds of auxiliary components such as the linkage with ALM, custody and corporate governance."
But he says that in a constantly changing environment - for instance, where the client is outsourcing more components of the investment process - the fiduciary consultant has a complementary role to the fiduciary manager.
"The fiduciary consultant should know what the fiduciary manager is doing and have a bird's-eye view of the whole process," he says. "It should ensure the manager goes through all elements of the process in the right way, ensuring that a best-of-breed solution is used and one which is best for the organisation as a whole."
He points out that this role is much broader than the traditional, more-detailed work consultants used to carry out.
"And it is a disadvantage for the consulting community wanting to create a fiduciary product," he says. "But the strength of the traditional consultant is that it had a small advantage in terms of trust, since it was considered to be independent."
Söhnholz does not see why fiduciary consultants and fiduciary managers cannot work alongside each other.
"The fiduciary consultant looks over the shoulder of the fiduciary manager, on behalf of the pension plan," he says. "Hiring a fiduciary consultant as well as a manager could increase costs, but two partners looking at selection and ensuring the best of breed is selected will improve the quality of investments, and any additional costs should be outweighed by the potential benefits. Sometimes, for instance, the consultant may know the different asset managers better than the fiduciary manager."
He says that fiduciary management has taken off in the Netherlands, while there is growing interest in Scandinavia and eastern Europe.
"The demands now are how to find alpha and best of breed," he says. "Low interest rates increase the values of liabilities and this means surpluses are under pressure, with the added risk of longevity. So it is more important to find extra alpha than a few years ago."
Van Dijk says that ironically, the search for alpha has made it easier for foreign companies to break into markets abroad.
"Whereas in some countries it used to be difficult for foreign managers to make inroads, clients are now saying they'll go with the best manager, since they will work to get the extra, say, 0.25%," he says. "We are quite surprised to see it happening now rather than further down the line. In particular, the transition is happening much faster than expected in Germany, France and Switzerland."
In terms of the future, he says: "Investment consultancy will totally change between those who become fiduciary managers themselves, those who go into asset management like Russell, and those who stick to their consulting but specialise in manager selection and fiduciary consultancy, such as Feri."
Meanwhile, Russell expects increasing complexity in the regulatory environment over the next few years, and believes that one way pension funds might be able to adapt is by appointing a fiduciary manager.
And Cras says that schemes will have to decide whether to build up their resources, or consider outsourcing.
"An important trend in the future will be for us to help pension funds improve their governance model, allowing trustees to focus their limited time on critical issues, such as the setting of investment objectives," he says. "In fact, some schemes already delegate the whole implementation of investment policy to a strategic partner."
He says Russell has a positive view on the fiduciary management model. "In terms of providers, we are currently seeing the barometer go up, with more providers coming on to the market. However, not many will succeed, and the barometer will go back down. Russell is very well-positioned at the moment. This is a market for us."