On holiday in Noosa many years ago, we decided that we would spend the day exploring the Sunshine Coast. As we only wanted a car for the day, and having been burnt by hidden fees in car rental contracts (don’t worry, not another fee article!), there was only one selection criteria, cost. So we settled on a small well-aged Daihatsu Charade at an equally small cost. We hopped into the car and my son immediately announced,
“we can’t drive this car, it doesn’t have airbags Dad”.
Having ridden in the back of a station wagon playing on a mattress all the way from Melbourne to the Gold Coast as kids, airbags were not exactly top of mind.
More recently, I was instructed that our new car must have multiple airbags (driver, passenger, side and ceiling!) and ESC, not that I knew what that was. Although, I am sure this was a ploy to get me to buy a more expensive car that he would soon be claiming as his own.
Bottom line, a high level of safety and protection was mandatory!
The multi-manager equivalent of the airbag is the fiduciary capacity in which investment managers are engaged on behalf of their clients. I don’t want to get distracted by the technical definitions or legal interpretations of fiduciary duty. I am talking about a trust based principle where investment managers invest in the best interests of their clients, including avoiding conflicts of interest. This provides funds with a core level of comfort and protection as investment managers are paid an explicit fee for acting solely in the interests of their client and its ultimate investors (e.g. members).
Over recent years we have seen an increasing use of services that don’t have the core protections of fiduciary obligations. The prominent examples are transition management services and foreign exchange services offered by custodians. Fortunately, these developments have coincided with the emergence of in-house investment teams that hopefully have sufficient expertise to evaluate, select and monitor such activities. Yet, my experience would suggest that non-fiduciary activities are not being subjected to greater or different levels of scrutiny, documentation and monitoring.
Low cost at what cost?
Custodians offering overlay services are an important example of the development of non-fiduciary investment services. They are often sold as a low cost and more operationally efficient alternative to appointing an investment manager.
Whilst this may on the surface appear very attractive, there are fundamental differences between the foreign exchange services offered by a custodian and an investment manager. Most importantly, custodians may not be operating in a fiduciary capacity, and in this case may be the principal or counterparty on many transactions.
Best execution, for whom!
Achieving best execution on behalf of clients is a fundamental tenet of investment management and the role of a fiduciary. This fundamental tenet affords significant comfort for clients. If the custodian decides the price at which it transacts your foreign currency transaction with itself (i.e. how much money it makes), then there are clearly some issues that need careful examination and ongoing monitoring. And unfortunately, statements such as; “we use a panel” are of insufficient comfort, and much more detailed scrutiny and consideration is required.
By the way, even if you don’t implement an overlay, this risk issue is likely to be currently present in your fund as significant foreign exchange activity is commonly implemented through your custodian. And the price at which you transact with your custodian may, by default, be determined by your custodian...nice work if you can get it!
In summary, there are clear benefits offered via a custodian overlay service, yet there are also consequences that may be undesirable and warrant different risk management approaches.
Transition trade-offs
Transition managers are another and more complicated example of a service provider that is typically engaged in a non-fiduciary capacity.
The few that are willing to operate in a fiduciary capacity (akin to an investment manager) will sell the peace-of-mind afforded by the fiduciary obligation. However, such transition managers are typically one-step further away from the sources of liquidity, as they are acting through brokers to get to the ultimate source of liquidity, the investment managers.
Given that the troublesome tail on a transition often requires the creation of liquidity by stimulating interest from investment managers, the brokers (non-fiduciaries) may be viewed as having an advantage by directly engaging with the ultimate source of liquidity.
I appreciate that this is a gross simplification, yet it may be viewed as a potential trade-off between fiduciary and non-fiduciary roles.
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Fit for purpose
It is not a question of it being right or wrong to engage service providers in fiduciary or non-fiduciary capacity, it is about being fit for purpose and understanding the implications. Just as you wouldn’t want airbags if you were racing around Phillip Island race track this weekend, you won’t always want to be engaging service providers in a fiduciary capacity.
The message is that the roles are distinctly different, and therefore require very different evaluation, appointment and monitoring processes.
Importantly, non-fiduciary roles require an additional layer of scrutiny, documentation and monitoring to protect your interests. However, anecdotal evidence suggests that such functions are actually receiving less scrutiny than their investment manager counterparts.