03/06/09 - Pension Consultants and Fund of Funds: The buck stops where?

By: Jason Whitby, CFA®, CFP®, MBA, AIF®

The most common investment model for pensions and endowments is based on picking the best investment managers.  This is typically accomplished with the help of a pension consultant who leads the manager evaluation and due diligence on behalf of the investment committee.  That investment model is under scrutiny in the aftermath of the Madoff scandal primarily as a result of consultants recommending Fund of Funds (FoF) to their clients.  Heavy weights such as David Swensen, Chief Investment Officer of Yale University's $17 billion endowment have been outspoken with blistering criticism.   When he was interviewed by the Wall Street Journal, David Swensen stated, "Fund of funds are a cancer on the institutional-investor world. They facilitate the flow of ignorant capital." ¹ When asked about consultants he replied, "Consultants make money by giving advice to as many people as possible. But you outperform by finding inefficiencies most of the market has not yet uncovered. So consultants ultimately end up doing a disservice to investors. " ¹ There are plenty of cases from pensions and endowments all over the US that would support his condemnation.  For example, take the West Palm Beach (WPB) Police Pension Fund:

"About 5% of the (WPB Police Pension) Fund's assets were invested with the Collins Low Volatility Performance Fund in October 2007, on a recommendation from a consultant, Asset Strategy Consultants.  The Collins fund consisted of a diverse group of 21 different funds.  About 10% of it had been invested with the Rye Select Broad Market Prime Fund L, which was an investment with Madoff." ²

I've included a flowchart, Appendix A, to help illustrate.  Now to be fair, the WPB pension only lost about 0.05% in the Madoff scandal.  But Madoff isn't really important to the main point.  Rather, look at how far removed the investment committee really is from the final investment.   Look at how many firms and intermediaries were involved, reduced transparency and charged fees for doing due diligence. This is what David Swensen meant by "facilitating the flow of ignorant capital." ¹ He didn't say dumb or stupid.  He said ignorant as in unaware, lacking knowledge in a particular area.  Basically it was impossible for the WPB Pension Fund to make an informed decision on the consultant's recommendation.  Then again, it would seem to have been impossible for either the consultant or the FoF to have actually done much due diligence on Rye and Bernie.  Of course that didn't stop them from collecting their fees.

Most likely you are wondering what manager due diligence really meant.  After all, entire industries were created on the premise of being able to deliver the best investment managers and to a great degree that turned out to be smoke and mirrors. The Yale CIO stated that there are two types of investors, "those who can hire high-quality, active-management investors and those who can't.  If you're not going to put together a team that can make high-quality decisions, your best alternative is passive investing." ¹ This is why Investor Solutions' focus is on markets, not managers.   It isn't that we don't have the desire or intelligence to hire high-quality managers.  It is just simple reality and common sense that passive indexing is our best option for success.  We recognize that we are not Yale or Harvard.  We are not a multi-billion dollar endowment capable of paying huge management fees, and most likely, neither are you.

Appendix A:  Down the Rabbit Hole

West Palm Beach Police Department Pension Fund hires Asset Strategy Consultants located in WPB, FL.  The consultant charges a fee for their services and manager due diligence.  They recommend 5% of the Pension fund be allocated to Collins Low Volatility Performance Fund.

Collins Low Volatility Performance Fund is a BVI registered Fund of Fund managed by Collins Capital based in Miami, FL. The fund charges a fee for their "ability to find the best managers balancing risk and reward".  The fund takes 10% of the money from the pension and invests in the Rye Select Broad Market Prime Fund.

Rye Select Broad Market Prime Fund is a single-manager hedge fund, 100% owned by Tremont which is 100% owned by MassMutual Life Insurance.  Rye charges 1% in fees for their services and manager due diligence.  Rye takes 100% of the money and hands it to Bernie Madoff.  Apparently 100% of Rye's ~$3.5 Billion was allocated to Bernie Madoff.

Bernie Madoff successfully runs a Ponzi scheme estimated at $50 Billion and lasting for more than 30 years.  WPB Pension Fund loses over $800,000 in the scandal.

¹ David Swenson, CIO Yale Endowment interview published by the WSJ on January 13, 2009

² Published by the South Florida Business Journal December 14, 2008

 

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