INSTITUTIONAL INVESTING AND THE MARKET FOR LEMONS

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1 INSTITUTIONAL INVESTING AND THE MARKET FOR LEMONS Observations on the evolution of institutional investment consulting Written by: Rob Woodard

2 The study of economics seeks to explain why consumers and producers behave as they do, what issues arise in the production and distribution of goods and services, and how the market responds to those issues in the pursuit of certain outcomes, such as fairness, efficiency, or profit. The concepts applied and the lessons learned can help inform other topics, including the continuing evolution of institutional investment consulting. Like the used car market, early efforts in investment consulting were focused on filling the void brought about by an informational asymmetry. In this case, there was a lack of expertise on the part of the consumer. The Market for Lemons In the August, 1970 publication of The Quarterly Journal of Economics, Professor George Akerlof published an article that 31 years later would earn him a share of a Nobel Prize in Economics. The article was entitled The Market for Lemons : Quality Uncertainty and the Market Mechanism, and it remains one of the most popular (as measured by professional citations and internet downloads) articles in all of economics. The article was not a critique on citrus, but rather the application of various economic concepts by way of an example that utilized the market for used cars. Colloquially, a lemon is a used car that has previously undisclosed problems. Since a prospective purchaser has less information than the seller of the true condition of a used car, Akerlof speculated that the price the purchaser was willing to pay would be reduced to reflect this quality uncertainty. Consequently, owners of high-quality used cars ( peaches, or maybe cherries to extend the fruit metaphor), would be incented to retain ownership. Absent market responses and adaptations, these diverse economic incentives would negatively impact the ability of an otherwise open and competitive forum to operate effectively.

3 While Akerlof was only employing used cars as a familiar example, it is easy to see how the market has produced several concrete responses to these economic incentives. In response to the imbalance of information available to the seller, but not the purchaser (referred to in economics as an information asymmetry), companies like CarFax, and more recently TRUECar, sprang up. These companies promise aspiring automobile owners the ability to attain better, or more complete, information about the history and value of any car. To increase a purchaser s confidence and familiarity, used car franchises arose (think Carmax or AutoNation). And, in an effort to combat the negative perception associated with used car sales, vast marketing campaigns and warranty programs were developed, including certified pre-owned designations designed to counter the perceived prevalence of lemons. One key conclusion from the Akerlof paper is that economics drive markets to adapt and evolve, and it is important to understand how incentives motivate and facilitate change. Investment Advice and Lemonade Though Dr. Akerlof remains much less well-known to the public than his wife (current 1 Federal Reserve Chair Janet Yellen), his contributions to the concepts of pricing dynamics in informationally skewed markets has been found to apply to countless areas, including the investment consulting industry. Like the used car market, early efforts in investment consulting were focused on filling the void brought about by an informational asymmetry. In this case, there was a lack of expertise on the part of the consumer. In addition, investment analytics, including portfolio modeling and risk assessment, were arcane and complicated. Access to data and the investment management community at large was limited. Fiduciaries, faced with the growing complexity of the institutional investment market, were hard pressed to carry out their duties with the care, skill, prudence and diligence of a prudent person familiar with such matters. Enter institutional investment consultants who brought with them not only expertise, but also portfolio modeling capabilities, data delivery (including performance reporting) and manager selection services, including underwriting, access and monitoring of managers. As with the used car complex, however, the broad market has evolved. Today, with the expansion of computing power, portfolio modeling (including mean-variance optimization, stochastic analysis and stress-testing) is widely available. Similarly, vast databases of information on indices, performance, managers and markets are readily available via the internet. The needs of institutional investors, particularly those with sufficient assets to support internal staff, have changed.

4 Meanwhile, the consulting industry has expended significant resources into traditional products and services, including manager databases, performance reporting and not surprisingly - more consultants. Growth at these firms has been significant and has occurred both organically and through consolidation. Incredibly, the top five institutional consultants now advise in excess of $21 trillion globally 2. These national firms provide a level of reputational comfort and familiarity, however, like the Big Mac, are not always associated with a gourmet experience, in spite of the millions served. Investment Consulting: Challenges and Opportunities The challenges to future growth and profitability in institutional consulting are clear: products or services that were once exclusive are now commonplace. Increased information and analytical capabilities that accompanied growth in computing power and access to data have democratized areas once considered the exclusive purview of the consultant. Small institutions who might still pay for these services are difficult to scale in a profitable manner, particularly for the larger consulting firms. The one traditional consulting service still in high demand is also the most difficult one to apply on a broad and profitable basis: experienced advice. Unlike data, performance calculations or manager searches, it is the one service not produced in bulk. In spite of long and impressive lists of firm clients, or armies of research analysts, the quality of investment advice a client receives is still largely dependent on the individual who attends the meeting. Investors, as with used car buyers, are wiser than ever with regard to this fact. Consequently, to facilitate ongoing growth, the traditional consulting model has changed. Many institutional consultants have moved to offer discretionary investment management to their repertoire of services. Discretionary investment management has always existed, but has more recently been discovered by consultants as an attractive economic opportunity. Whereas consulting revenue is often based on fixed-retainer fees, asset management fees grow with the assets. Similarly, investment management is scalable, as a strong investment platform can readily be expanded to service more assets. As a consequence, discretionary consulting, often referred to as outsourced chief investment officer (OCIO), has exploded. According to Charles Skorina & Company, a national executive search firm, the top ten firms in OCIO space have expanded by over 48 percent in assets under management in the last two years 3. While some of these firms are, and always have been, exclusively investment managers, six of the top 10 are traditional consultants. Similarly, the largest traditional institutional consultant is also the largest discretionary or OCIO consultant in the country.

5 The practical implications of being a consultant who is also in the money management and asset gathering business are many and varied. As with the inner workings of the modern automobile, the breadth and depth of investment management choices make it extraordinarily difficult for stewards of institutional assets, whose business and expertise are rarely institutional investment management, to effectively evaluate the process and products being offered. This is particularly true for smaller investment portfolios that cannot economically support internal staff with sufficient expertise to represent the firm. Like Akerlof s hypothetical used car purchaser, they enter the equation without an independent advisor and are faced with an overwhelming informational asymmetry. We believe this sequence of events has created a new opportunity by way of a return to an old concept. The Role of Mariner Institutional Consulting Mariner Institutional Consulting is designed to do one thing: to act as a truly independent advocate for our clients, with the expertise and experience necessary to level the informational playing field. To be successful in this endeavor requires an organizational and economic focus. As such, we have chosen to bypass opportunities to develop products, to recommend or consider affiliated products, or to offer discretionary investment management (or outsourced chief investment officer) services. Instead, we emphasize a truly customized approach to each client and to each task. We offer ongoing education and dialogue with clients and transparent communication of our processes, analysis and recommendations. In the area of strategic allocation and investment implementation, we focus on helping design, build and maintain portfolios that are no more complex than necessary and are risk and cost justified at each level. To reinforce this mindset, we are structured to be capable of adapting our services to fit the needs of our clients, rather than applying a single platform and approach to all situations. And, we intentionally price our services in an inclusive manner, eliminating incentives that could drive ancillary activity or charges. Consequently, in addition to more traditional consulting services like strategic allocation, performance measurement and manager underwriting, we are also engaged to provide oversight and assessment of other service providers (including OCIO managers), strategies and performance. In this sense, we often operate as an extension of staff in acting as an expert resource for our institutional clients.

6 The primary tradeoff is economic, since this approach is not consistent with building a behemoth consulting organization, or with organic revenue growth tied to assets under management. We believe that maintaining fewer, more highly relational, customized and collaborative consulting relationships is, however, more likely to produce a significant positive impact. That makes this not only a good market niche to fill, but also is consistent with, and supportive of, our personal and professional values and objectives. If your organization is looking for a different consulting approach, or if you feel your efforts might benefit from an informed, independent and fresh perspective on your investment portfolio and its management process, we hope you will consider a conversation with Mariner. And we won t try to sell you a lemon FOR MORE INFORMATION CALL: CLICK: References Akerlof, George A. The Market for Lemons : Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics 84.3 (1970): 488. Print. Wikipedia contributors. George Akerlof. Wikipedia, The Free Encyclopedia. Wikipedia, The Free Encyclopedia, 26 Sep Web. 28 Sep As of March, Largest Investment Consultants Pensions & Investments. Crain Communications, Inc., 30 Nov Web. 17 Mar Skorina, Charles. OCIO Update: More Firms, Another $24 Billion. Charles Skorina & Company. Charles Skorina & Company, 26 Sept Web. 17 Mar The information contained herein is not intended to be personal legal, investment or tax advice or a solicitation to buy or sell any security or engage in a particular investment strategy. Nothing herein should be relied upon as such. The views expressed are for commentary purposes only and do not take into account any individual personal, financial, or tax considerations. There is no guarantee that any claims made will come to pass. Mariner Institutional Consulting ( MIC ) is an SEC registered investment adviser with its principal place of business in the State of Kansas. Registration of an investment advisor does not imply any level of skill or training. MIC and its representatives are in compliance with the current registration and notice filing requirements imposed upon registered investment advisers by those states in which MIC maintains clients. MIC may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements. Any subsequent, direct communication by MIC with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For additional information about MIC, including fees and services, please contact MIC or refer to the Investment Adviser Public Disclosure website (www. adviserinfo.sec.gov). Please read the disclosure statement carefully before you invest or send money Mariner Institutional Consulting. All Rights Reserved.