Trends in asset consulting

Trends in Investment Consulting

Transformation of the South African fund management industry continues to be both a priority and challenge. However, I would argue that transformation of the fund management industry is inextricably linked to transformation of the investment consulting industry. This is because investment consultants, through their advice to retirement fund trustees, play an important and in fluential role in terms of allocation of retirement fund assets. We therefore cannot expect transformation within the fund management industry to gain further traction until transformation also becomes a priority within the investment consulting industry.

The purpose of this article is to discuss the dual investment consulting model, which is already being tested and applied in the industry. This could be an opporttment consulting industry but as I will argue below, an opportunity to also improve the governance and robustness of investment decisions made by retirement fund trustees.

What is the dual consulting model?

A few of the larger retirement funds in South Africa have adopted a dual-consulting model. This involves appointing two investment consultants, who are independent of each other, to provide investment advice. The investment consulting companies can either have overlapping or non-overlapping service level agreements with the retirement fund.

In situations where the consultants have overlapping service level agreements, the retirement fund effectively receives two opinions on the same matter. In this way, the retirement fund builds-in an alternative opinion within the overall investment decision-making process. This helps to facilitate greater debate and discussion of complex investment matters in order to improve overall investment decision-making, as well as the confidence of the Board of Trustees in the decisions that they have taken.

Alternatively, the retirement fund may award separate and non-overlapping service level agreements to the investment consulting firms. In this way, the retirement fund recognizes the strengths (and weaknesses) of the two investment consulting companies and works to utilize the investment consultants in their respective and complementary areas of strength.

Some retirement funds have used the dual consulting model to facilitate enterprise development and transformation by supporting small consulting or black owned and managed consulting companies. Small businesses play an important role in terms of job creation, which is a national priority. Boutique, black- owned asset managers have reated many jobs and allowed the youth to gain valuable experience within
the financial services industry. Consider the member of jobs that could be created if similar support was offered to boutique, black owned consulting firms.

The concept of peer review is also well established in academia, the sciences and the actuarial profession. When applied to complex retirement fund investment decisions, peer review should deliver the same quality of thought process, leading to the delivery of more desired outcomes for all retirement fund stakeholders including members, the regulator and government.

What are the benefits for retirement fund trustess?

Often there is no wrong or right answer when dealing with investment issues – therefore the decision-making process in arriving at a particular outcome must be robust. This is particularly important within a defined contribution environment where members and Trustees bear the risk of failed investment strategies, as opposed to an employer or sponsor. For this reason, retirement funds pursuing a dual-consulting approach tend to have a more comprehensive audit trail of decision-making, which improves transparency to various stakeholders and confidence in the decision-making process.

Investments is a complex and evolving field. It may be easier for Trustees to grasp complex issues and make more informed investment decisions by allowing different perspectives on an issue to be actively debated between the two informed and professional investment experts. The dual consulting model also offers a greater breadth of ideas and opinions, enabling the retirement fund to better keep pace with all of the changes and developments within the investments field.

The dual consulting model allows investment issues to be prioritized more effectively and assists with managing the Board’s governance budget, including time allocation. Trustees may develop greater conviction in decisions in instances where both investment consultants agree. On the other hand, in instances where the two consultants disagree, Trustees may exercise greater caution or allocate more time to investigate the matter further.

Investment consultants have different “styles” or methods of operating and different skill sets and experience. Some companies may be more quantitative in their approach whereas other companies may be more contrarian. Some companies may have a global focus (as retirement funds can invest more offshore in terms of Regulation 28) whereas others may wish to focus on targeted or socially-responsible investments to foster local growth and development. Trustees may tap into the collective expertise of both consultants or utilize the strengths of each consultant as it sees fit or as is appropriate to different situations or decisions.

What are the challenges of the existing single consulting model?

As Bruce Came on puts it, investment consultants are meant to act as “watchdogs” ¹ for retirement fund trustees. They should retain some distance from other service providers (rather than receive remuneration from or build business relationships with them) in order to remain as objective as possible. Greater objectivity should “level the playing fields” and create an environment in which asset managers compete on merit.

Investment consultants should only generate fees from providing independent investment advice in order to align themselves completely with the interests of their clients. However, this is a challenging business model and as a result there are only a few truly independent investment consulting companies left in South Africa that fit this mould.

The primary challenge is that investment consulting is a low margin industry. As a result, many investment consulting companies have offered additional services to retirement funds in order to generate additional revenue. There is nothing wrong with this, especially if the additional services add value. However, with each additional service there is a real risk that explicit and implicit conflicts of interest develop between the investment consultant and their retirement fund client, thereby creating a non-alignment of interest and, possibly additional costs, both explicit and implicit.

One example of such additional services is transition management.

Some investment consultants have set up transition management businesses that charge a (more preferred) basis point fee per transition. There is therefore an incentive (even if only at a sub-conscious level) for the consulting division to recommend asset manager or product changes (based on short-term performance) more frequently than necessary in order to generate business for the transition management division. In this case, retirement funds not only suffer from unnecessary transition costs and the negative effects of short-termism but also from the opportunity cost of changing asset managers or switching between products at, more often than not, the wrong times.

The additional services can and do add value to retirement funds, when applied correctly. However, the multiple roles described above do risk moving the investment consultant’s interests further away from those of the retirement fund and its members, creating conflicting incentives.

How the dual consulting model seek to address these challenges?

Firstly, it allows for better management of conflicts of interest and improved accountability. In instances where one of the investment consultants is conflicted in some way, the other investment consultant provides independent oversight in addition to the retirement fund’s established processes in dealing with the conflict of interest.

The dual consulting model is beneficial in situations where one investment consultant is dominant and has a significant information advantage over the Trustees. Rob Rusconi referred to the “information inequity” (in his discussion document: “South African Institutional Investments – Whose Money Is It Anyway?”) ² that exists between Trustees and service providers and how this is usually to the disadvantage of and sometimes actually exploited to the detriment of Trustees and hence the retirement fund. An additional investment expert within the decision-making process serves to level the playing fields and ensure that the information inequity is not exploited to the detriment of the retirement fund and its members.

All human beings are subject to behavioural biases and investment consultants are not exempt. Investment consultants may be biased in terms of their preferences for certain strategies or service providers. Where two independent experts are applying their minds, it should be easier to recognize and mitigate these biases and their effects. The dual consulting model therefore reduces the risk that these biases feed into final decision making.

The dual consulting model may be a good opportunity to encourage transformation and enterprise development within the investment consulting industry thereby enabling greater diversity of opinion and more robust investment decisions. Diversity is one of the strengths of South Africa and could result in long-term capital allocation decisions being better suited to the needs of South Africa. Support of boutique asset managers and investment consultants should further job creation efforts.

Some degree of healthy competition between the two investment consulting companies may lead to better service levels for retirement funds. The track record of the consultant can now also be maintained making each consultant more accountable for their advice.

What are the disadvantages of the dual consulting model?

There is a risk that the dual consulting model delays decision-making, especially if the two investment consultants differ with each other for the sake of differing. This model therefore requires the investment consultants and the Trustees to create an environment of mutual respect. However, some would argue that any decision-making delays will be in areas where a delay is actually warranted. In addition, taking long-term decisions requires an additional layer of scrutiny and research so spending time on these decisions is entirely appropriate for long-term investors.

Retirement funds will need to spend additional time managing the two consultants, especially where the level of competition is fierce. The arrangement is more complicated but this complexity does seem to be warranted given the complexity of the tasks and decisions involved. The benefits of the dual consulting model may therefore outweigh the additional complexity that is introduced.

The dual consulting model may lead to an increase in investment consulting fees. Costs are important as they impact significantly on members’ net replacement ratio on retirement. However, this is limited if the investment consulting budget is essentially split between the two appointed investment consultants. Even where there is an increase in combined consulting fees, this should be marginal relative to the improved decision-making, resulting in investment returns and risk outcomes that better match the fund’s requirements, as well as the governance and other benefits associated with the dual consulting model.

Conclusion

Investment consultants must be objective and select asset managers on merit. They should be independent and put the interests of their clients ahead of their own business interests. It is human nature for relationships to sometimes cloud objectivity and for bias, whether intended or unintended, to affect recommendations to clients.

The dual consulting model may be one way of addressing some of the shortcomings of the single investment consulting model as it effectively builds-in an expert alternative opinion at different levels of the investment decision making process at little or no cost. It also offers an opportunity to facilitate transformation and enterprise development in the investment consulting industry. This can only improve outcomes for all retirement fund stakeholders over the long-term.

References

¹ Cameron B (2012), Savings industry needs a change of course, Personal Finance, September

² Rusconi R (2008), South African Institutional Investments – Whose Money Is It Anyway? A Discussion Document, January