The old-school model of hiring an investment consultant to dispense advice to sponsors of pension funds and endowments about prospective investment managers is passing away.

Now, such consultants are morphing into more hands-on strategists, acting as outsourced chief investment officers. In this new role, they take charge of hiring and firing managers, as well as overseeing the allocation of assets in a given portfolio or set of portfolios.

Why?

According to white paper by consulting shop Greycourt, the dotcom bust was a major catalyst that pushed institutional investors, who ignored their consultants' advice to rebalance out of skyrocketing growth and tech stocks, to consider asking their consultants to take discretion over their portfolios. And the 2008 financial crisis served to push the steady trend toward seeking discretionary advice to "became a virtual torrent."

"The concept really has been around for quite some time, especially with foundations,'' said Brian Ternoey, Investment Consulting Practice Leader, for Curcio Webb, which has offices in Deer Park, Ill., Pennington, N.J. and San Francisco. "It is one of the most significant changes in the consulting area because a lot of large firms have repositioned themselves to benefit from this."

Ternoey, who spoke on a panel of consultants recently gathered at the Global Indexing & ETFs conference in Phoenix to discuss the challenges and pitfalls of outsourcing chief investment responsibilities, also noted that a lot of institutional clients are considering outsourcing CIOs because of their own lack of resources.

"This produces a lot of conflicts between traditional investment management firms and consultants who are getting into their spaces," he said.

By Ternoey's estimates, roughly $300 billion changes hands primarily between endowments, foundations and corporate plans and their outsourced CIOs, right now. This is growing at about 15% to 20% per year, he projects. This falls in line with estimates from consulting firm Casey Quirk, which forecasts that the $250 billion a year outsourced CIO market will double by 2016.

Outsourcing the chief investment officer functions can save money and provide financial flexibility to funds. But, here are cautionary tales on how much to rely on outsiders for such critical functions as hiring and firing of managers and choosing what assets to invest in.

Ronnie Jung, former executive director at the Teacher Retirement System of Texas, said his former system's long-time consultant of 30 years fired them "because they could make more money doing money management than getting a small fee from us for their advice."

Jung has reservations about the model. "I still have trouble with an outsourced CIO because I consider that to be a contracted employee. So if you do outsource your CIO, do you still need your consultant to be independent?'' he said.

The biggest challenge, he says, is to get independent advice from a consultant's staff.

"It's hard now because our current consultant (Hewitt) merged two or three times and I don't even know what their name is (Hewitt EnnisKnupp) anymore, and they've gotten away from performance attribution to discretionary management,'' he said. Their charge has become much broader, in the process. "It's moved significantly from adviser (and) independent consultant to being involved in the day-to-day management of investments," he said.

Charlie Chittenden, a pension actuary at Buck Consultants in Atlanta, shared a cautionary tale from his firm's experience. Years ago, he worked with a consulting firm called Alexander and Alexander in Atlanta. One of its advisory clients was a multi-employer pension fund in Miami.

When he took over that assignment as an actuary, his boss told him the fund had hired an investment consultant that he had already knocked heads with and cautioned Chittenden to be deferential to him. The consultant's firm had structured the agreement for him to serve not just as a custodian of the fund's assets, but an investment consultant that could hire and fire all of the fund's investment managers.

The consultant, in the process, tried to put some of the fund's assets in a stock fund that his firm ran. The fund's trustees didn't want that because that was a conflict where he might get a commission that was in addition to the fees they were paying him.

But that didn't deter the consultant. He then told the fund's trustees they should put 10% of their assets into a hedge fund.

After that, "he ripped off the back page of a prospectus, which was the signature page, and took it to one of the union trustee and said, 'You voted to go into the hedge fund so you have to sign this to do so.' But he didn't show the prospectus to anyone such as the lawyer, accountant, or actuary," said Chittenden.

"The consultants in our firm found a prospectus for the fund that he had put them in and it turned out to be a limited partnership interest in a general partner, which was the investment consultant's firm. So he generated a commission of $850,000 within his firm and the trustees knew nothing of this,'' he said.

After finding out, the trustees were furious with the investment consultant for investing in his own firm except for one trustee, which thought it was fine because he said commissions get paid in this business and that the consultant shouldn't be fired because "it's better to deal with the devil you know than the one you don't," Chittenden said.

But the prospectus specifically stated that the hedge fund would not accept any money from Employee Retirement Income Security Act funds and this was clearly an ERISA fund that had invested $14 million in this limited partnership and already lost $100,000 by the time this came up.

"So we insisted that the whole transaction would have to be reversed and the investment consulting firm resisted that. There was a three-month period before the commission would actually get paid and so the consultant was trying to drag this out so he can get paid,'' he said.

The trustees were able to reverse the transaction and the fund got its money back. The fund never fired the consultant but his firm did. The fund hired an auditor, which then urged the fund to split up the investment management and custodian functions, which it eventually did.

"The consultant started his own firm and he's still practicing and I've seen his name as a speaker at conferences like this, so I don't think there's anything new under the sun," added Chittenden.

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