Sunday, 29 September 2013

Biting the hand that feeds

The FT last week published a story looking at a recent Saïd Business school study on Pension Fund Consultants, and their lack of value added. In fact, they seem to be value destructive according to the study.

This immediately made me think of Leo Kolivakis’s recent Pension Pulse article on Hedge funds, and how the consultants tend to push large funds over small, despite small funds getting better performance.

This is not a new phenomenon, and it is not just confined to the Pension Fund industry. Back in the 70’s and 80’s, it was well known that “No-one ever got fired for buying IBM”. I remember as a junior US analyst opening my FT one morning to see an advert by Compaq, who were setting all sorts of records at the time for revenue growth, S&P inclusion, etc. “and no-one got promoted for buying IBM either”.

There are many reasons for these trends, but I would suggest career risk is actually the biggest. As Leo put it:

“Fifth, there is a herd mentality among large investors who pretty much all invest in the same large brand name funds. Much easier to go in front of your board if some well known fund you invested in is performing terribly and say "everyone was invested in this fund, they had stellar performance in previous years and we were caught off guard by their recent dismal performance." It's all about managing career risk and those allocating to hedge funds rarely, if ever, stick their necks out to invest large amounts in smaller hedge funds because if something goes wrong, they're cooked!!!”

When I tried to set up my own funds and I had managed to get myself in front of consultants and managers here in Canada, they told me the same thing; They knew I could do the job as well as any “known” firm, but if this was the year I had bad performance, their bosses would crucify them. I could come back in 3 years, with at least $100M under management, and then we might talk.

I was told recently that one of our major Pension funds here had no Canadian managed funds in their external portfolio. Funds normally suffer from Home Market bias, the tendency to view more favourably the markets one knows best, so one would expect Canadian managed funds to be overrepresented, not under.

When I look through the list of Emerging Markets mutual funds offered to retail here, I am always shocked how few are managed here. The list of fund continues to grow, but when you drill down, they are managed outside of the country, even when sponsored by our largest banks.

Would I be pushing the bounds of credulity to suggest that there is a correlation between the lack of support for start-up firms and the outsourcing of so much of our funds under management?

Now many people will come back that there are fiduciary duties to uphold and due diligence to be performed, all of which is true. Regulations were, at least in theory, put in place to protect against some kind of problem.

And despite all those regulations and due diligence to protect us, we still have Madoff, SAC, and a host of others.

I have described a particularly Canadian situation, but the Saïd study above is for American funds. I would hazard a guess that you would see similar results if you analyzed European funds. Local differences abound, but the underlying problem remains: the playing field is tilted too steeply against new funds.

Not all is lost. I was talking to Ramy Zakher at OMERS recently who told me they had started to look at firms who had only $50M under management, but they would be looking to take a stake in the company for their funding. This is a huge step forwards.

Here in Quebec, we have, at least in theory, a scheme to support new funds, but sadly, execution so far has been less than adequate. So bad in fact that the backers of the program have started to ask why the managers are sitting on their hands, and starting to hold them accountable

What solutions would I propose?

I would recommend everyone involved, but especially the beneficiaries and trustees of schemes, to start asking what their managers and consultants are doing to recommend smaller firms. Given that these funds have better performance, don’t trustees have a fiduciary duty to be asking the question?

I would recommend regulators introduce more asymmetric regulation, with sensibly easier rules for smaller funds. When I managed long - short for High Net Worth clients, I was doing it on a managed account basis, so I had no access of any sort to the client funds, and all the trades I executed were reported directly to the clients, who were all accredited investors. Yet I had to put up the same regulatory capital as if I were a hedge fund, which ended up killing the project.

Many US States have rules to invest minimum amounts with minority owned firms. How difficult would it be to extend that to firms below say $250M AUM?

For large State funds, the press should be asking why so much is outsourced to external managers. Some administrations have a problem paying “Wall St” wages, but are happy to pay millions in fees to Wall St. There are a lot of good managers and analysts who would be very happy making a good salary at a State fund. Ontario Teachers’ Pension Plan would be a fantastic role model for them.

Consultants need to be more proactive. They need get involved at a much earlier stage and to set up platforms that are easy for anyone to promote themselves, even a dart-throwing monkey. Instead of complaining that smaller funds need to do a better job marketing themselves, they should be helping them market themselves – the whole point is that you want the smaller funds to be managing money.

I am probably wildly optimistic, but I believe that if small firms can get this kind of support, it can rapidly become a self-sustaining “ecosystem”, as successful funds grow, and unsuccessful ones die, their seed capital gets returned to the pool to seed the next generation.

Post Script.

As I was proof reading this, the FT published a follow up article on consultants here

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