October 6, 2014 | Posted in The Hidden Cost of Poor Advice | By

Promotion and Benchmarking of Alternatives by Consultants Questioned: £5bn Underperformance in LGPS revealed.

CLERUS today released a new report which reveals that investment consultant’s promotion of alternative investments to LGPS does not stand up to proper scrutiny. It also raises important professional and ethical questions around the integrity of the performance benchmarks used to assess, and remunerate, alternative managers. Finally, it also highlights the risk to performance where decision-makers lack the expertise to properly challenge the ‘expert’ advice given to them.

Report Summary:

  • Performance assumptions used to promote alternatives to Local Authorities (LGPS) do not stand up to proper scrutiny and are inconsistent with realised past performance
  • Lack of integrity of alternative benchmarks has ‘hidden’ 0.5% per annum, or £ 5 billion in poor performance over 10 years, excluding excess incentive fees paid on below target performance
  • More than £20 billion worth of alternatives and absolute return products benchmarked, and remunerated, inappropriately using cash-like benchmarks in LGPS alone

LGPS regulations require administering authorities to take ‘proper advice’ when making investment decisions. However ‘proper’ is not well defined and does not oblige LGPS to scrutinise the quality of advice prior to making investment decisions. The report highlights the need for improved governance in this area and illustrates why this should include scrutiny of the risk and return assumptions used in various asset-liability simulations to promote alternative investments.

UK consultants’ recommendations also appear to be going against the tide of industry leaders. Examples include California Public Employees’ Retirement System (“CalPERS”) and their decision to divest from hedge funds stating excessive cost and complexity, and the decision in 2013 by the £73bn Danish Labour Market Pension Fund (ATP) to close down its own $1.9bn ‘alpha’ program citing that it had become time-consuming and expensive.

In the event that the original LGPS reform proposals were carried through, Local Authorities would still end up paying £301 million of annual fees, and 58% of total fees, to an 11.5% allocation to alternatives. However, as the data has shown, these alternative investments have historically provided lower return than bonds or equities, and were achievable by simple de-risking.

The dressing-up of investment performance by setting alternative performance benchmarks too low leaves financial intermediaries as winners, while plan sponsors and tax payers lose out.

1) Local Authorities are more likely to be able to report ‘above benchmark performance’
2) Investment advisors can finally report that their ‘buy-rated’ managers beat benchmark
3) Investment managers earn higher fees (including potential performance fees) for longer as their performance looks better than it is and cannot be assessed correctly

Henrik Pedersen, Managing Partner & Co-Founder of CLERUS said:

“The attraction of alternatives is predicated on the ability of consultants to identify the small percentage of managers who might be able meet the unrealistic risk and return assumptions into the future. However, actual performance data published over the last decade in both traditional and the much more complex alternative assets, suggests that this is an unlikely proposition.”

“A typical transition from equities to alternative managers requires the selection of between three and five additional managers, and subsequent monitoring. This is good business for investment consultants, however, as the data have shown, it is has not been so good for LGPS or taxpayers.”

“The report asks a simple question: Why are these products being promoted as providing equity-like returns, but benchmarked and remunerated against cash-like benchmarks?”

“The potential monetary impact and scale on plan sponsors and taxpayers from the lack of integrity of performance benchmarks used to assess and remunerate managers and advisors raises important professional and ethical questions.”

“We recommend that local authorities, and trustee boards, invest to acquire the expertise to challenge the advice they receive from their consultant, before taking any investment decisions. The pay-back of a small investment in improved governance and transparency will be fast and any costs will be far outweighed by the benefits of better investment returns.”

To read the full report “Mis-selling of Alternatives by Investment Consultants? A Review of Methods used to Promote Alternatives and Dress-up Performance” click here

CLERUS was founded to offer independent senior investment management, governance and decision-making expertise to Pension Funds or other asset owners looking to evaluate the efficiency of their current investment management process.

CLERUS co-founders Henrik Pedersen, MBA and Richard Rothwell, FSIP, ASIP are both seasoned financial experts with many years of applied institutional investment experience, which they recognise could be of value to those pension-fund investment-decision makers, who might lack the applied investment experience to question the investment advice they receive.

CLERUS investment governance and performance review process been has developed and successfully deployed to evaluate and improve the performance of investment decisions within leading investment firms and over many years.

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