Harrison Fiduciary

Outsourced Chief Investment Officer — More Questions Than Answers

Pension investment consultants have found their latest fad …..outsourced CIO services….otherwise known as OCIO.

From benchmarking, to style boxes, every couple of years the investment consultants cook up a new fad to sell to retirement plan fiduciaries.  As a business model, replenishing the product line has served the consulting industry very well.  The question, however, is “how well have the plans performed using their advice?”

And now, the industry is off on its newest fad:  OCIO.  While each firm might tailor their services in a unique manner, the general theme is the same. Rather than offering traditional consulting services, with an OCIO, a plan turns over its entire portfolio to the consultant to be managed.

Presto Change-o!!!!  The lowly consultant morphs into the coveted role of investment manager.  Rather than receiving a fee for consulting services they can now charge fees based upon the assets under management.  And, who knows? If they are lucky, they may even get a performance fee: the holy grail of asset management.

FundFire reports on this industry trend, Consultants Tweak Outsourced CIO Message.  As FundFire explains, however, there is a lot of confusion underlying the OCIO title and the services actually being provided.   This confusion requires the industry to “Tweak”  its message.  In fact, one public plan rejected the shift from traditional consulting to OCIO because of the lack of clarity surrounding these services and this role.

Two points in this article jumped out at me.

First, a critical term is missing. Neither the consultants, nor the article, mention the term “fiduciary”.  This entire model is presented as an asset gathering and fee generating exercise by the consultants.   But where is the fiduciary obligation to the plans and the participants?

Second, the article, in the opening paragraph, references potential “new conflicts of interest” presented by this new arrangement, but does not fully explore these conflicts.  Very often consultants provide multiple services to their clients.  Adding a OCIO role can add to these potential conflicts.

Furthermore, consultants also have significant relationships with other investment managers.   This side of the relationship equation is very murky.  How will the consultant  select managers for its OCIO services?   How will these services be priced?  These are just the start of the questions.

From the perspective of the consultant industry, it is completely understandable that they want to explore new ways to develop their services.  As Shale Lapping, president of IPEX, an independent consulting firm in Plymouth, MI states, “the ability to generate additional revenue is obviously an attractive position …. The margin has always been smaller for consultants (than for managers); that’s not secret in the industry. [Outsourcing] brings in higher margins and makes it easier to retain quality talent.”

This is well and good for the consulting industry.

At Harrison Fiduciary Group, we unequivocally and categorically reject this form of the  OCIO business model as embraced by many consultants.  While it might make sense for the consultants, it doesn’t necessarily makes sense for clients.

On one level, we do support the delegation of investment oversight, monitoring and management to outside, independent experts. In contrast, however, at HFG our business model starts and finishes with our role as a fiduciary for plan assets.  First, we provide a single service to plan sponsors — fiduciary services.  We don’t have multiple services to sell, or rather cross-sell, to a plan sponsor.  We have no ability to increase our fees with a client.  We also do not have affiliates such as broker/dealers which also can give rise to conflicts of interest.  Plain and simple, we pledge:  No Conflicts of Interest.

Importantly — and maybe even heretically in our business — we will charge a flat fee for our services.   We are not engaged in an asset gathering exercise and will not charge a basis point fee for assets under management.  Anwill bed, of course, we will never charge a performance fee. Instead, our flat fee is based upon (i) the complexity of an engagement, (ii) the resources needed to execute the project and (iii) the fiduciary risks which we assume.  Our fees will never increase simply because the value of a particular market increases.

To use a much over used expression; “we are thinking outside of the box”.  We present an alternative business model for the oversight, monitoring and management of retirement assets.  We are competing against traditional big players in our field.  However, we have a principled and new approach which puts the best interest of plan participants at the core of our business model.

We are not embracing a fad by serving as a fiduciary.  The duties of a fiduciary harken back to the 16^th century.  At Harrison Fiduciary Group we serve a time honored role.

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No One Seems to Care about Conflicts

A member of the board of trustees of a NY City private school provides information to a prospective parent about the school.  Sounds simple enough, but then the parent pays the trustee for the information.  Say, what?

Apparently, there is a business in this.  The NY Times reports that Aristotle Circle provides these various contacts to otherwise unconnected NYC parents.  Let’s set aside for a moment, the hyper-aspirations of parents and the crazed environment for coveted spots in select pre-schools.  Instead, let’s focus for a moment on the trustee who provided these services.

Serving as a trustee on the board of a non-profit is a fiduciary position.  The trustee owes a fiduciary duty to the Board and the organization.  Receiving a fee from a third party for either access to the school or information about the school is a gross example of self-dealing.  This trustee should be thrown off the board, ASAP.

The bigger issue, however, is how come this trustee is so tone deaf to a blatant conflict of interest?  Did the trustee have any qualms about these actions?  Furthermore, how does Aristotle Circle build a business model on these fee for services, and introductions?

A few weeks ago, Berkshire Hathaway announced that David Sokol had made personal investments in a company in which he then encouraged Warren Buffet to buy.  Neither Buffet, nor his right hand man Charlie Munger, seemed to think that there was anything wrong with these actions.  Sokol tendered his resignation only after pressure was raised by outsiders.

Whether it is the heir apparent of Berkshire Hathaway or an ambitious NY city parent, no one seems to be bothered by these conflicts of interest.

Try as we may to overcome the financial crisis through new rules and regulations.  No meaningful progress can be made until we address this very simple business proposition.  People who hold positions of trust — in any organization — must avoid any appearance of a conflict of interest.

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A Never Ending Source of Fees for the Pension Industrial Complex

Roger Lowenstein refers to our public pension system as The Great American Ponzi Scheme.  While supportive of the policy needs to provide pensions to public workers, I suspect that he comes to his Ponzi Scheme conclusion because of the vast gaps in funding of many state and municipal plans. Many current retirees enjoy healthy payments, while the system remains significantly underfunded.  A little bit like the Madoff investors who took out big returns as other investors were making additional contributions.

With respect to the funding issues, Lowenstein is right on point.  And, the funding issue is probably the biggest challenge facing the public system.  However, Lowenstein overlooks another critical dynamic of the pension system; that is, the investment of retirement assets and the fees paid to all of the various vendors.  Again, in the aggregate, the funding issue looms larger.  But, every dollar paid to a vendor is one less retirement dollar paid to retirees.  Research shows that these fees have a significant impact on investment returns.

If the funding system is a ponzi scheme, then the investment process for public plans is also, in many cases, a sham of another sort.

Last spring I spoke about fiduciary matters at a conference sponsored at Harvard Law School for trustees of public pension plans. The vast majority of the participants were policeman, fireman, teachers and other public employees who serve as trustees for the their retirement plans.  After spending a day working in small workout groups with the conference participants, I was struck by two significant insights:  1) the vast majority of these trustees are earnest and take their responsibilities very seriously and 2) notwithstanding this earnestness, they are no match for Wall Street.

I suspect that for some of these trustees, their formal education may have stopped at high school.  And particularly for teachers, their college careers were directed to towards degrees in education.  In contrast, the investment management industry is filled with algorithm yielding MBA’s and finance PhD’s from Ivy League schools.  In fact, one session of the conference was devoted to a liability-matching strategy so loaded with math and investment jargon that I’m convinced that my CFA partners would have been challenged to translate the strategy so that I could digest it.

This is not the exception, but the rule.  Investment concepts and the intricacies of investment products have become so extraordinarily complicated that even the best intention plan trustee cannot understand the fundamentals.   And yet, public funds continue to direct assets to the latest hedge fund or strategy pumped out by the investment management industry.

Sanity must be injected into the system.  Not only are public pension funds under funded but,  their assets no doubt are invested in expensive products, the majority of which produce average returns.  The math is not good.   Average returns and high expenses mean overall lower returns for retirees.

For the past 20 years the investment industry has fed at the trough of the $ trillions held by public pension plans.  The industry has profited beyond its wildest dreams.  Unfortunately, the retirees have not been so fortunate.

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David Sokol’s Resignation from Berkshire Hathaway Doesn’t Pass the Smell Test

Full disclosure:  I have been a long time shareholder of Berkshire Hathaway.  Therefore, I’m particularly disappointed with the current episode of bush league antics from corporate America.  I expected more from Berkshire, Warren Buffet and Charlie Munger.

I want to set aside the legal analysis of whether Sokol’s action constitute insider trading or a breach of a duty to the corporation, shareholders or anyone else.  No doubt, talented lawyers will line up arguing both sides of these issues.  Irrespective of the final legal assessment, these facts stink.

As reported in yesterday’s New York Times, by Reuters, Sokol learned about Lubrizol  because Citigroup had an investment banking assignment from Berkshire to bring potential acquisition targets to Berkshire’s attention.   In effect, Sokol learned about the Lubrizol opportunity in his capacity as an employee and officer of Berkshire.  He then took that information and used it for his own benefit.

This egregious behavior was then compounded by the fact that he turned around and pitched the Lubrizol deal to Buffet.  He also attended a meeting with Lubrizol’s CEO in the process — no doubt that he scored this meeting because of his position at Berkshire, it was not in his personal capacity as an investor of $10 million in Lubrizol’s stock.  (Although a lot of money, $10 million investments don’t typically afford an investor a one-on-one meeting with a CEO).

Simply put, Sokol abused a position of trust.  Buffet and Munger’s failure to call him out on it only exacerbates these inexcusable actions. In fact, Munger makes the tired excuse: “Few people understand how good he is, how really good he is”.  In other words, he’s so good that he is above the rules. The ultimate rationale of elitism; members of the club can’t possibly do anything wrong.

Corporate governance experts are explaining that Berkshire’s internal policies (Code of Conduct, Insider Trading Policy, Conflict of Interest Policy, etc) need to be reviewed and possibly re-vamped.  As a fiduciary, I am a huge proponent of rigorous policies and procedures.  However, policies and procedures are only as good as the judgment of the people who enforce them.  Nothing replaces strong business ethics.  And, as anyone who has worked at in a large organization knows — a culture of strong business ethics  starts at the top.

Buffet and Munger’s staunch support of Sokol sends a strong message not only through the capital markets, but also throughout the entire Berkshire entity.  Just possibly, there are two sets of rules:  one set for the rank and file and one set for those who are “really good”.  In large organizations everyone sniffs out these double standards and the integrity of the culture begins to erode.

Our financial system has survived a near death experience.  Congress attempted a legislative fix through Dodd-Frank which is now mired in a political and regulatory  morass.  As I have stated before, real reform will never occur until behavior is reformed. We need business leaders with the courage to proclaim that conflicts of interest are intolerable and unacceptable. Failure to do so undermines the integrity of our financial system.

Warren Buffet use to be such a leader.  For decades, he has only taken a minimal salary from Berkshire for the stated reason that he wanted his interests to be aligned with shareholder interests.  A noble and unique position in corporate America.   Somehow David Sokol missed this message.  Maybe he and Buffet should pull out some of the old Berkshire annual reports.  They provide an exemplary primer on corporate ethical behavior.

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