Investment Management: Key Practices Could Provide More Options for Federal Entities and Opportunities for Minority- and Women-Owned Asset Managers
Released: 2017-09-20T00:00:00


Highlights: section_title: Why GAO Did This Study
paragraphs: Asset management firms registered in the United States manage more than $70 trillion. MWO firms manage less than 1 percent of those assets. The federal government has an interest in increasing opportunities for MWO businesses. Questions have been raised about how often federal entities use MWO asset managers and the transparency of their selection processes. GAO was asked to examine, among other things, (1) competitive challenges MWO firms face and how institutional investors address them, (2) selected federal entities' use of MWO firms, and (3) the entities' asset manager selection processes, including their use of key practices. GAO reviewed investment policies and financial statements of 8 entities that manage or sponsor federal retirement plans, an endowment, and an insurance program. GAO also interviewed 14 state, local, and private retirement plans and foundations and 10 MWO asset managers (selected based on size and other factors).

section_title: What GAO Found
paragraphs: According to asset managers and industry associations with which GAO spoke, minority- and women-owned (MWO) asset managers face challenges when competing for investment management opportunities with institutional investors, such as retirement plans and foundations. For example, institutional investors and their consultants often prefer to contract with large asset managers with brand recognition and with whom they are familiar. Also, small firms, including MWO firms, are often unable to meet minimum requirements set by institutional investors, such as size (assets under management) and past experience (length of track record). State, local, and private retirement plans and foundations GAO interviewed addressed these challenges in a variety of ways, such as asking their consultants to include MWO firms in their searches. Many plans also lowered their minimum threshold requirements so that the requirements were proportional to the size of the firms while maintaining the same performance requirements for all asset managers in their selection processes.

Federal retirement plans, the endowment, and the insurance program GAO reviewed invest in asset classes in which MWO asset managers have a market presence, but overall use of MWO firms varied. For example, some retirement plans either did not use any MWO firms or did not track this information. The endowment and insurance program reported using some MWO asset managers.

GAO identified four key practices institutional investors can use to increase opportunities for MWO asset managers. These practices are consistent with federal interests in increasing opportunities for MWO businesses.

Top leadership commitment . Demonstrate commitment to increasing opportunities for MWO asset managers.

Remove potential barriers. Review investment policies and practices to remove barriers that limit the participation of smaller, newer firms.

Outreach. Conduct outreach to inform MWO asset managers about investment opportunities and selection processes.

Communicate priorities and expectations. Explicitly communicate priorities and expectations about inclusive practices to investment staff and consultants and ensure those expectations are met.

Some federal entities we reviewed, such as the Federal Reserve System, have used all the practices, but others made partial, limited, or no use of the practices.

The Federal Retirement Thrift Investment Board does not intend to use the practices in its planned mutual fund window platform.

The Navy Exchange Service Command and Tennessee Valley Authority Retirement System used one practice, but have not used the others.

The Army and Air Force Exchange Service has used two practices, and partially used two practices.

By using the key practices, the entities GAO reviewed could widen the pool of candidates in their asset manager searches and help ensure that they find the most qualified firms. In keeping with federal interests, the practices could also help address barriers MWO firms face and increase opportunities for them.

section_title: What GAO Recommends
paragraphs: GAO makes four recommendations to increase opportunities for MWO firms, in keeping with federal interests. Four federal entities should use key practices, as appropriate. The Army and Air Force Exchange Service, Navy Exchange Service Command, and Tennessee Valley Authority Retirement System agreed. The Federal Retirement Thrift Investment Board disagreed. GAO maintains that key practices should be used, as discussed in the report.

section_title: Letter
paragraphs: Asset management firms registered in the United States managed more  than $70 trillion as of May 2017, but asset management firms owned by  minorities or women (MWO asset managers or firms) manage less than 1  percent of these assets. Despite this small percentage, some industry  reports indicate that an increasing number of state, local, and private  pension plans and other institutional investors have started using MWO  asset managers. According to other industry reports, using these  managers could provide investors with potential benefits, such as  generating a broader range of investment ideas. Yet, in recent years, the asset management industry also has become more concentrated, with  the bulk of institutional assets managed by the largest investment firms.  Specifically, the 100 largest asset managers account for more than 50  percent of total reported assets.

The federal government has an interest in increasing opportunities for  minority- and women-owned businesses and helping address barriers  they face. For example, the federal government has established a  number of programs that assist small businesses, including those that are  minority- and women-owned, when they seek to contract with federal  agencies. Officials that administer these programs have identified  challenges these businesses may face in contracting with the federal  government and have taken actions, such as conducting outreach, to help  address them. Additionally, the Minority Business Development Agency in  the Department of Commerce was created to foster the growth of  minority-owned businesses of all sizes, and does this through, among  other things, programs and services that increase access to capital,  contracts, and markets. The agency has also identified challenges faced  by minority-owned businesses and taken steps to help address them.  More recently, the Dodd-Frank Wall Street Reform and Consumer  Protection Act includes a provision requiring certain agencies to develop  procedures to ensure the fair inclusion of women and minorities in  contracting, among other things.

In July 2015, members of Congress hosted a summit with representatives  of several federal retirement plans and an insurance program to discuss  barriers and other constraints to engaging MWO asset managers. At the  summit, the congressional members announced the formation of a  working group to develop strategies for addressing the structural barriers  that have prevented meaningful inclusion of MWO asset managers and  committed to more robust congressional oversight of federal retirement  plans and endowments moving forward. Policymakers have continued to  raise questions about the transparency of the asset manager selection  processes the federal entities used and the lack of diversity in federal  asset management overall. You asked us to review the challenges MWO  firms may face when competing for opportunities to provide asset  management services and the use of these firms by selected federal  entities. In this report, we examine (1) the challenges MWO asset  managers may face when competing for investment opportunities, and  practices used by selected state, local, and private entities that administer  or oversee retirement plans and foundations to increase opportunities for  MWO firms; (2) the major asset classes in which selected federal entities  invest, their use of MWO firms, and the market presence of MWO firms in  these asset classes; and (3) the policies and processes selected federal  entities use to identify and select asset management firms, and their use  of key practices to increase opportunities for MWO asset managers.

We reviewed federal retirement plans, an endowment, and an insurance  program administered or overseen by eight federal entities (collectively  referred to as federal entities): Army and Air Force Exchange Service,  Federal Reserve System, Federal Retirement Thrift Investment Board,  Railroad Retirement Board, Smithsonian Institution, Pension Benefit  Guaranty Corporation, Navy Exchange Service Command, and  Tennessee Valley Authority. We selected federal entities and the  National Railroad Retirement Investment Trust that had assets exceeding  $1 billion in 2015 and used passive or active strategies (or both) to  manage investments.

To identify challenges MWO asset managers face, we analyzed reports  by industry stakeholders, such as trade associations, institutional  investors, and investment managers. We interviewed 10 MWO asset  managers and 4 MWO brokerage firms—selected based on size (assets  under management or revenue), literature reviews, and recommendations  from industry stakeholders. To identify how entities that administer or  oversee state, local, and private retirement plans and foundations  (nonfederal plans and foundations) increase opportunities for MWO firms,  we interviewed 14 entities—selected based on size (assets), use of an  MWO program or other initiative to increase opportunities for MWO asset management, a literature review, and recommendations by industry  stakeholders. We also analyzed reports by industry stakeholders on key  practices for MWO programs or similar initiatives.

To determine the major asset classes in which selected federal entities  and the National Railroad Retirement Investment Trust invested, we  obtained data from the entities and reviewed their annual reports and  audited financial statements. To determine the presence of MWO firms in  the same asset classes invested in by the federal entities and the  National Railroad Retirement Investment Trust, we reviewed publicly  available directories and databases of MWO asset managers. We then  reviewed the firms’ Form ADV filings in a publicly available Securities and  Exchange Commission database to identify the asset classes in which  they operate and the assets they reported managing. We then  compared the total assets reported by MWO firms we identified to total  regulatory assets under management reported by all investment advisers  in the database as of May 2017. To the extent available, we reviewed  data on the percentage of each federal entity’s and the National Railroad  Retirement Investment Trust’s asset managers that are minority- or  women-owned, percentage of assets the firms managed, and asset  classes in which firms invested. To assess the reliability of data in the  Securities and Exchange Commission database, we identified and  removed duplicate entries, checked data from the database against a  selection of firms’ original filings, and compared total regulatory assets  under management for all firms in the database to an industry estimate of  the global asset management industry. To assess the reliability of data for selected federal entities and the National Railroad Retirement Investment  Trust, we interviewed representatives of the plans and Trust with  knowledge of the systems and methods used to produce these data. We  determined the data we used were sufficiently reliable for the purposes of  our reporting objectives.

To determine how federal entities and the National Railroad Retirement  Investment Trust identified and selected asset managers and their efforts  to include MWO firms, we analyzed investment policies; documentation  on selection processes and criteria; and documentation on programs,  policies, or initiatives related to MWO asset managers. We also  interviewed representatives from the entities we reviewed to learn more  about selection processes and efforts related to MWO asset managers.  We assessed the extent to which the federal entities used key practices  to increase opportunities for MWO firms. We identified key practices by  examining the practices used by selected nonfederal plans and  foundations and by reviewing industry reports. We then validated the  practices by obtaining input from 10 industry stakeholders and experts,  selected based on factors such as depth of experience working with  MWO firms and published research. We discuss our scope and  methodology in greater detail in appendix I.

We conducted this performance audit from April 2016 to September 2017  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
subsections: section_title: Background
subsections: section_title: Federal Institutional Investors
paragraphs: Institutional investors include public and private entities that pool funds on  behalf of others and invest the funds in securities and other investment  assets. Examples of institutional investors include federal, state, and local  government, and private retirement plans, endowments, and foundations.

In 2015, the eight entities we reviewed held close to $388 billion in  externally managed investment assets used to support their investment  objectives, including funding retirement benefits for federal employees  (see table 1). They administered or oversaw defined benefit retirement  plans, defined contribution retirement plans, an endowment, and an  insurance program, each with distinct investment objectives.

Three of the eight entities we reviewed manage defined benefit  plans that provide participants a retirement benefit amount using a  formula based on factors such as years of employment, age at  retirement, and salary level. Typically, benefits are paid from a fund  made up of assets from annual contributions by employers,  employees, or a combination of the two and investment earnings from  those contributions. Defined benefit plans typically have investment  policies and guidance that outline goals for how the funds are to be  invested.

One of the eight entities we reviewed sponsors a defined  contribution plan in which employees and employers contribute to  an account directed by the employee into investment options offered  by the plan. Policy objectives for defined contribution plans typically  focus on offering a range of prudent investments suitable for  participants to direct contributions in ways that meet their personal  investment objectives.

Two of the eight entities we reviewed both manage defined benefit  plans and sponsor defined contribution plans.

Two of the eight entities we reviewed hold other types of investments.

The Smithsonian Institution manages an endowment, which is  comprised of trust funds, the majority of which have been permanently  restricted by donors for a particular use, such as acquisition of  artwork, funding curator positions, or public programs, according to  agency officials. The Pension Benefit Guaranty Corporation operates  an insurance program designed to partially insure defined benefit  pensions sponsored by private employers. While the Pension Benefit  Guaranty Corporation insures the pension benefits of nearly 40 million  workers and retirees, as a federal guarantor of these plans it takes  over the assets of underfunded terminated plans and is responsible  for paying benefits to participants who are entitled to receive them.

section_title: Investment Decisions and Stakeholders in the Investment Process
paragraphs: For the defined benefit plans, endowment, and insurance program we  reviewed, the entities generally make investment decisions within a  framework spelled out in investment policy statements approved by  boards of directors, trustees, or regents. Their investment policy  statements generally define an asset allocation, or mix of asset classes in  proportions designed to meet the entity’s overarching investment  objectives. For defined contribution plans, participants make investment  decisions by deciding how to allocate the contributions they and their  employer make among investment options offered through the plan.  Entities that administer these plans may outline these options in plans’  investment policy statements. For three entities in our review, legislative  mandates also specify certain investment decisions, such as asset  diversification and investment options.

The federal entities we reviewed and the National Railroad Retirement  Investment Trust are fiduciaries that have responsibilities that are typically  similar to those of private sector retirement plans in that they are required  to act solely in the interest of participants and beneficiaries in the  retirement plans. These responsibilities may include acting with the  exclusive purpose of providing benefits to the participants and  beneficiaries and defraying reasonable expenses of plan administration;  carrying out their duties prudently; following the plan documents; and  diversifying plan investments.

A number of stakeholders are typically involved in the investment  process. Generally, investment boards of directors or trustees, investment  committees, investment officials and staff, investment consultants, asset  managers, and brokers work together to invest clients’ funds in securities  that match clients’ financial objectives (see fig. 1).

The defined benefit plans, endowment, and insurance program we  reviewed generally retained external asset managers to select individual  investments in accordance with the asset allocation frameworks in their  investment policy statements. The defined contribution plans generally  retained external asset managers to provide plan participants with  investment options. Asset management firms typically select investments  on behalf of the investors that hired them and regularly report on  investment performance. Many earn income by charging service fees  based on a percentage of assets they manage. These fees generally  include the costs of trading charged by brokerage firms.

section_title: Asset Classes and Portfolio Management
paragraphs: Asset management firms registered in the United States manage more  than $70 trillion. Although thousands are registered to operate in the  United States, the 100 largest asset managers account for more than 50  percent of total reported assets under management. Institutional investors  we reviewed work with asset managers to typically invest in or offer  participants investments in four broad asset classes: equity, fixed income,  alternative assets, and cash and cash equivalents.

Equity indicates ownership in a business in the form of common stock  or preferred stock. The equity asset class includes mutual funds,  collective investment trusts, and exchange-traded funds that invest in  equity securities.

Fixed income refers to any type of investment under which the  borrower or issuer is obligated to make payments of a fixed amount  on a fixed schedule. The fixed-income asset class includes mutual  funds, collective investment trusts, and exchange-traded funds that  invest in fixed-income securities.

Alternative assets can include hedge funds, private equity, real  estate, and commodities. Plans may make such investments in an  attempt to diversify their portfolios, achieve higher returns, or for other  reasons. In recent years, two of the most common alternative assets  that institutional investors held were hedge funds and private equity.

Cash and cash equivalents are the company’s assets that are cash  or can be converted into cash in a very short period of time. They  include bank accounts, marketable securities, commercial paper,  Treasury securities, short-term government bonds (with maturities of 3  months or less), short-term certificates of deposit, and money-market  funds.

Institutional investors generally use (or offer to participants) passive or  active portfolio management strategies, or a mix of both. Passive  management involves buying or creating an investment portfolio that  closely tracks the performance of a broad class of assets usually defined  by an index, such as the S&P 500. Passive managers attempt to match  the performance of an index, typically with lower fees than active  managers. Active managers attempt to exceed the performance of an  index using their judgment about which individual investments in that  asset class will do better than average. In defined contribution plans, the  portfolio management is directed by the participants based on the range  of options provided by the plan.

section_title: Federal Regulatory Requirements
paragraphs: The Federal Acquisition Regulation (FAR) establishes uniform policies  and procedures for the acquisition of goods and services by executive  agencies. Among other things, the FAR includes requirements agencies  must meet, such as full and open competition through competitive  procedures. With the exception of the Pension Benefit Guaranty  Corporation, the FAR does not apply to the asset manager selection  processes used by the federal entities or the National Railroad  Retirement Investment Trust, according to representatives we  interviewed.

section_title: Minority- and Women- Owned Asset Managers Face Challenges, but Found Opportunities at Some Nonfederal Retirement Plans and Foundations
paragraphs: According to many asset managers and industry associations with which  we spoke, MWO asset managers face various challenges when  competing for investment management opportunities with institutional  investors, including retirement plans and foundations. However,  nonfederal plans and foundations with which we spoke used various  approaches to help address many of these challenges. These plans and  foundations cited several factors that led them to take steps to increase  opportunities for MWO firms. For example, some noted organizational  interest in diversity as the driving force behind more inclusive selection  practices for asset managers. Others cited potential benefits of using  MWO firms, such as helping to diversify risk in their portfolios.

Investor and consultant brand bias. According to most asset  managers and industry associations we interviewed, institutional  investors and their consultants often prefer to contract with larger  asset managers with brand recognition or with whom they are familiar.  Furthermore, according to some asset managers and industry  associations, unless clients directly ask for MWO firms to be included  in asset manager searches, consultants generally will not include  them. For example, one industry association noted that consultants  generally exclude MWO asset managers due to an implicit bias that  their clients’ investment portfolio performance could potentially suffer  if they use a MWO firm despite no information to indicate this would in  fact be the case.

Having recognized brand bias as a challenge for MWO firms, some  nonfederal plans and foundations have asked their investment  consultants to maintain an inclusive process for sourcing, evaluating,  and recommending investment managers across race, ethnicity, and  gender. One of these plans and a local plan in Illinois told us that they  asked their investment staff or consultants to ensure that at least one  qualified MWO asset manager was invited to present to the  institutional investor’s decision-making body. In addition, one  foundation ensured that its consultant was held accountable to more  inclusive processes by requiring its investment consultant to annually  report the number of diverse managers evaluated, recommended, and  hired across the consultant’s client base.

Perception of weaker performance. According to most MWO asset  managers and industry associations with whom we spoke, MWO firms  may face challenges because institutional investors generally have a  perception that MWO asset managers do not perform as well as non- MWO firms. However, a May 2017 study on diversity in the asset  management industry by an academic institution and a research  group found no differences in the performance of funds managed by  MWO firms and the performance of those managed by non-MWO  firms, among the firms they analyzed.

Furthermore, all nonfederal plans and foundations we interviewed told  us that all firms managing assets in their respective portfolios,  including MWO asset managers, were selected based on track record  of performance and evaluated against the same performance  standards as other asset managers in their portfolios. In addition,  some nonfederal plans noted that these asset management firms may  provide certain benefits in generating profit for their clients. For  example, one plan noted that MWO firms offer more differentiated  investment strategies than larger firms.

Size and infrastructure. The size and limited infrastructure of  smaller, newer MWO firms also may pose challenges. For example,  according to most asset managers and industry associations with  which we spoke, small MWO asset managers are frequently not able  to meet threshold requirements set by institutional investors, such as  minimum limits established for assets under management, liability  insurance, and length of track record. Moreover, an asset manager  and some nonfederal plans and foundations noted that back office  functions and operational costs, such as for accounting and  compliance, are high and make investments in these areas difficult for  smaller, newer firms (including many MWO firms).

In light of these minimum threshold challenges for MWO firms and  smaller firms in general, many nonfederal plans adjusted  requirements to allow these firms to compete, while noting that they  maintained the same performance requirements for all asset  managers in their selection processes. Specifically, most nonfederal  plans and two foundations either lowered their minimum requirements  for assets under management, length of track record, or amount of  liability insurance to help ensure the requirements were proportional  to the size of the firms, or did not set any minimum or maximum  assets under management threshold levels. As we will discuss later,  the Federal Reserve System and Pension Benefit Guaranty  Corporation have made similar adjustments to increase opportunities  for MWO asset management firms. Representatives from most  nonfederal plans, foundations, the Federal Reserve System, and  Pension Benefit Guaranty Corporation stated that they have not  sacrificed performance or fallen short of their fiduciary responsibility in  increasing opportunities for MWO firms.

Industry trends. In May 2016, we reported that defined contribution  plans have replaced defined benefit plans and become the dominant  form of retirement plan for U.S. workers over the past three  decades. According to some asset management firms and industry  associations, MWO firms face challenges due to this industry shift  from defined benefit plans toward defined contribution plans where  business opportunities for MWO firms may be too costly. The  marketplace shift from defined benefit to defined contribution plans  also will likely drive up costs for asset managers and branding will be  more important for defined contribution plans because asset  managers will need to interact more directly with participants,  according to an industry association we interviewed.

The industry shift from active management to passive management  may also be a challenge. According to some asset managers, industry  associations, and nonfederal plans we interviewed, MWO firms are  less able to compete at defined contribution plans with passive  management investment strategies because MWO firms lack the size  and resources that larger firms have to keep asset management fees  low for clients. Furthermore, because asset management fees for  passive management strategies are low, an asset management firm  must have a volume of business large enough to be profitable.

In addition to adjusting minimum size and length of track record  requirements, the nonfederal plans and foundations with which we spoke  developed other strategies to help increase opportunities for MWO asset  management firms.

Some nonfederal plans and one foundation allocated a target amount  of their investment portfolio to MWO asset managers. For example, to  help increase opportunities for MWO asset management firms, a local  plan in Texas developed a program that sets aside 10 percent of its  total assets across all asset classes to be managed by asset  management firms with $50 million or less in assets under  management and at least 30 percent ownership by minorities or  women. In addition, some nonfederal plans said they have  developed emerging manager programs. For example, a state  retirement plan in California has an emerging manager program— generally defined as a program geared towards newer, smaller asset  managers—wherein each of the plan’s asset classes has emerging  manager definitions based on assets under management, length of  track record, or both. In the plan’s private equity class, emerging  managers do not have to meet a minimum track record requirement  and must have $1 billion or less in assets under management.

Most of the nonfederal plans with whom we spoke used a fund-of- funds structure, in which a larger fund works as an intermediary for  multiple, smaller managers. Three of these nonfederal plans noted  that working with one firm to recruit, select, and manage underlying  firms was an efficient and effective means of working with smaller,  newer managers, including MWO firms. For example, a local  government retirement plan in Illinois noted that the fund-of-funds  manager they hired was able to hire MWO firms much more quickly  than they would have been able to directly. Similarly, a foundation that  sought to increase diversity told us that it specifically hired a fund-of- funds manager to help find MWO firms for its foundation. In addition,  three nonfederal plans noted that another benefit to hiring a fund-of- funds manager was that the firm could serve as a mentor (providing  guidance and coaching to the smaller asset management firms and  MWO firms), which can help build institutional relationships over the  long-term.

Nonfederal plans and foundations also helped increase opportunities  for MWO firms by using outreach strategies to identify MWO  managers that could meet their investment needs. For example, many  nonfederal plans regularly participated in networking events, such as  conferences, with MWO asset managers or networked with asset  management trade associations that represent MWO firms. Many of  these nonfederal plans facilitated one-on-one interactions with MWO  firms so prospective asset managers could better understand their  selection processes.

section_title: Federal Entities We Reviewed Invest in Asset Classes in Which Minority- and Women-Owned Asset Managers Have a Presence, but Use of these Firms Varied
paragraphs: The federal entities we reviewed and the National Railroad Retirement  Investment Trust invested primarily in equity and fixed income, while  some also invested in alternative assets or maintained some level of cash  and cash equivalents. The 2015 allocations of the defined contribution  plans we reviewed, shown in table 2, reflect both the investment options  plans offered to participants and participants’ decisions about how to  invest among them.

Valley Authority Savings and Deferral Retirement Plan also used  BlackRock to offer passively managed funds in which participants  invested over 60 percent of total 2016 plan assets (see sidebar).  Similarly, the Federal Reserve Thrift Plan contracted with six large asset  managers to offer the plan’s 12 funds. Eight of these, accounting for  nearly three-quarters of participant investments, were passively  managed. The defined contribution plans’ use of passively managed  funds may limit opportunities for MWO firms. As discussed earlier, the  shift toward defined contribution plans and passive management poses a  challenge for MWO firms. In particular, some asset managers and  industry associations with whom we spoke said MWO firms lack the size  and resources to compete with the low fees larger firms can offer through  passive management.

The federal defined benefit plans we reviewed and the Smithsonian  Institution endowment generally invested more extensively in alternative  assets in addition to equity and fixed income. As shown in table 3, in 2015  the Smithsonian Institution invested more than half the endowment’s  assets in alternative assets. Fiduciaries of four of the five defined benefit  plans in our review also invested substantially in alternative assets,  ranging from about one-quarter to about one-third of plan assets. The  Pension Benefit Guaranty Corporation generally does not invest in  alternative assets, but does hold a limited amount of these assets in line  with its investment policy.

We determined that MWO asset managers operate in the asset classes in  which federal entities and the National Railroad Retirement Investment  Trust invest. To do so, we identified more than 180 asset management  firms designated through publicly available sources as having some level  of minority- or women-owned ownership. These MWO asset managers  operate in all four asset classes in which the entities in our review  invested or offered investment options to participants. MWO asset  managers we identified reported managing assets totaling more than  $529 billion. As shown in table 4, most operate in the equity, fixed  income, or alternative asset classes. The market presence of these  firms equaled less than 1 percent of all regulatory assets under  management. Two of the firms, with combined regulatory assets under management of about $42 billion, identified themselves as specializing in  passive management investment strategies.

Although we identified MWO asset managers operating in each of the  four major asset classes, use of MWO asset managers in 2015 and 2016  by the federal entities we reviewed and the National Railroad Retirement  Investment Trust varied (see table 5). For example, in 2015, none of the  three defined contribution plans we reviewed used MWO asset  managers. Four of the five defined benefit plans we reviewed reported  using at least some MWO asset managers, but one of these plans did not  track this information and was unable to provide us with specific data on  its use. Finally, the Pension Benefit Guaranty Corporation did not use  MWO asset managers in 2015, but did retain four MWO asset managers  in 2016.

The Federal Reserve System’s, National Railroad Retirement Investment  Trust’s, and Smithsonian Institution’s use of MWO asset managers for  their defined benefit plans and endowment was proportionately higher  than the market presence of such firms. In 2015, 5 of the Federal  Reserve System Retirement Plan’s 32 asset management firms (16  percent) were MWO firms. These firms managed 2 percent of the plan’s  total assets, totaling $253 million. Four of these asset managers were  private equity firms. The fifth handled a portion of the plan’s fixed income  portfolio with two other asset managers handling much larger portions of  plan assets under a similar investment strategy. The MWO asset  manager achieved investment performance for the plan in 2015  comparable to that achieved by the two larger asset managers. In 2016,  10 of the National Railroad Retirement Investment Trust’s approximately  140 asset management firms (about 7 percent) were majority owned by  women and minorities. Collectively, these 10 firms managed about 5  percent of total plan assets. Additionally, another 46 of the plan’s asset  management firms had some level of ownership by minorities and  women. Representatives of the Smithsonian Institution estimated 14  percent of their asset management firms—equal to about 13 of the more  than 90 firms the endowment retained as of the end of 2016—were  owned by women or minorities.

In comparison, we identified a number of nonfederal entities that use  MWO asset managers. These include retirement plans in five states, one  of which set a goal of having 20 percent of its plan’s assets managed by  MWO asset managers. We also identified three foundations that  increased opportunities for MWO asset managers, for example by  amending their investment policy or establishing a program to hire MWO  asset managers. Finally, we interviewed officials from two corporations,  one of which retains MWO firms for both its defined contribution and  defined benefit plans. Representatives of the other corporation told us  they retain almost 30 MWO firms to manage nearly $600 million, or about  4 percent, of the corporation’s defined benefit plans and foundation.  Despite not having an explicit program in place to hire these firms, the  corporation cited two key actions that create opportunities for MWO firms  to compete. The first is conducting outreach so MWO asset managers  understand how to do business with the corporation. The second is  communicating to the plan consultant that the corporation expects to see  a diverse array of firms when selecting asset managers.

section_title: Some Federal Entities Made Limited Use of Key Practices When Selecting Asset Managers
paragraphs: Asset manager selection processes varied by federal entity, but generally  included conducting research to identify potential asset managers and  conducting an evaluation of potential asset managers before making final  selections. We identified four key practices that institutional investors can  use to increase opportunities for MWO asset managers: establishing and  maintaining top leadership commitment, removing potential barriers,  conducting outreach to MWO firms, and communicating priorities and  expectations about inclusive practices to investment staff and  consultants. Some of the federal entities we reviewed implemented all  these key practices, but others made partial, limited, or no use of the  practices.
subsections: section_title: Asset Manager Selection Processes Varied by Federal Entity and Some Entities Relied More on Consultants Than Others
paragraphs: All the federal entities we reviewed had internal policies related to their  selection processes for asset managers. The processes generally  included conducting research to identify potential asset managers and  evaluating candidates before making final selections, but varied in some  respects as the examples below show. We did not evaluate the National  Railroad Retirement Investment Trust’s asset manager selection  processes because it is not a department, agency, or instrumentality of  the federal government, and it is not subject to the federal law that  governs the financial operations of the federal government and  establishes the powers and duties of the GAO.

Selection criteria. All the entities had performance requirements and  most had minimum requirements related to size (assets under  management) and length of track record, but the thresholds asset  managers had to meet for these requirements varied. For example,  the minimum size requirements were $1 billion in assets under  management for two of the defined benefit plans we reviewed, and  ranged from $1 billion to $60 billion in assets under management for  the defined contributions plans. The minimum size requirement for the  Pension Benefit Guaranty Corporation was $250 million in assets  under management for applicants in the smaller asset managers pilot  program (discussed later in the report), and ranged from $10 billion to  $50 billion for managers outside of the program. Minimum length of  track record requirements ranged from 3–5 years for two of the  defined benefit plans we reviewed, and ranged from 3–15 years for  the defined contribution plans. The minimum length of track record  requirement for all managers used by the Pension Benefit Guaranty  Corporation was 5 years. In addition to performance, size, and length  of track record, the entities we reviewed used other criteria when  selecting asset managers, such as investment strategies,  diversification of portfolio, organization and resources, and best  value.

Use of public solicitation process. The Pension Benefit Guaranty  Corporation and the Federal Retirement Thrift Investment Board use  full and open competition when selecting asset managers. Full and  open competition allows all prospective asset managers who meet  certain requirements to submit bids or competitive proposals. The  Pension Benefit Guaranty Corporation and Federal Retirement Thrift  Investment Board seek competitive proposals from prospective asset  managers by issuing requests for proposals, which are published  publicly on the Federal Business Opportunities website. Asset  management opportunities for the other entities are not published  publicly. Instead, the entities use other avenues such as internal  investment staff or consultants to identify potential asset managers,  as discussed later in this report.

Frequency of asset manager searches. The Federal Retirement  Thrift Investment Board solicits asset management services for its  four externally managed funds every 5 years. The Federal Reserve  System reviews its public markets asset manager arrangements at  least every 5 years and, based on the results of the review, may  search for new asset managers. Pension Benefit Guaranty  Corporation officials told us that their asset manager searches are  ongoing, with generally from one to three searches occurring each  year for varying asset classes. The rest of the entities we reviewed do  not have a set schedule for conducting asset manager searches.  Asset manager searches for these entities typically occur when an  asset manager underperforms and needs to be replaced, there is a  change in asset allocation that warrants a new asset manager, or  when a new investment opportunity arises.

Almost all of the entities used consultants to some extent in their selection  processes, but some entities relied on consultants more than others.

Three entities (Army and Air Force Exchange Service, Navy  Exchange Service Command, and Tennessee Valley Authority  Retirement System) work closely with consultants. While these  entities approve final asset manager selections, the consultants  primarily drive the search and evaluation process. Specifically, the  consultants identify potential asset managers from their proprietary  databases based on the entities’ selection criteria. The consultants  then produce evaluation reports on candidates for the entities to  review and provide recommendations about which asset managers to  select.

Three entities (Federal Retirement Thrift Investment Board, Pension  Benefit Guaranty Corporation, and Smithsonian Institution) told us  they use consultants to help identify potential asset managers or  provide expertise on other areas, such as specific asset classes or  asset manager fees. However, evaluations to select asset managers  are conducted internally by the entities. As stated earlier, the Federal  Retirement Thrift Investment Board and the Pension Benefit Guaranty  Corporation issue requests for proposals, which allow prospective  asset managers to submit proposals to be considered for asset  management opportunities. The entities evaluate the submissions and  then make final selections. The Smithsonian Institution’s investment  staff prepare a memorandum after reviewing and vetting asset  managers. The memorandum is provided to the endowment’s  Investment Committee, which makes final selections.

Federal Reserve System representatives told us they primarily rely on  internal market searches to identify potential asset managers for both  of its retirement plans, but use consultants in limited instances.  Specifically, the Federal Reserve System uses a consultant for asset  classes in which it may be difficult to find asset managers, such as  real estate. After identifying potential asset managers, the Federal  Reserve System issues a request for proposal to potential candidates.  Candidate submissions are graded using a scoring matrix and the  results are used to identify from three to five firms, which then are  invited to interview. Final selections are made following the interviews.

section_title: Some of the Federal Entities We Reviewed Made Limited or No Use of Key Practices
paragraphs: We identified four key practices that can be used as part of investors’  asset manager selection processes to help broaden the processes and  ensure that qualified MWO firms are considered (see table 6). We  identified the key practices based on a review of industry reports and  interviews with a sample of state, local, and private retirement plans and  foundations. We then validated the practices by obtaining feedback from  experts and industry stakeholders. The key practices are closely  related, and improvements or shortfalls in one practice may contribute to  improvements or shortfalls in another practice. The practices do not  require investors to develop targets or allocations for MWO asset  management firms or to change performance standards. In addition, we  identified examples of how some institutional investors have implemented  the key practices, which may provide insights to other investors as they  undertake or attempt to strengthen or improve their own initiatives related  to MWO firms. The examples are not exhaustive and each institutional  investor may implement the identified practices in its own way.

As stated earlier, many nonfederal plans and foundations we interviewed  have implemented these practices to increase opportunities for MWO  firms and told us that using the practices does not conflict with their  fiduciary responsibilities. According to these plans and foundations, MWO  firms they used were selected based on track record of performance and  may provide certain benefits in generating profit for their clients.  Furthermore, according to plan representatives and other industry  stakeholders with whom we spoke, diversifying plan investments to  manage risk can be accomplished through the diversification of asset  managers. Industry reports and industry stakeholders, including plan  representatives with whom we spoke, also noted that implementing a  more inclusive selection process for asset managers can widen the pool  of candidates, which can help ensure that retirement plans and  foundations are identifying the best asset managers.

Additionally, as stated earlier, the federal government has an interest in  helping increase opportunities for minority- and women-owned  businesses and addressing barriers they face. The key practices we  identified, which can broaden an investor’s pool of asset manager  candidates to help ensure qualified MWO firms are considered for asset  management opportunities and increase opportunities for these firms, are  consistent with this interest.

We found that three of the federal entities we reviewed used all the  practices, but the other four entities made partial, limited, or no use of  them (see table 7).

Specifically, the Federal Reserve System and Smithsonian Institution  have developed inclusive policies and taken other steps to increase  opportunities for MWO asset managers, and the Pension Benefit  Guaranty Corporation has developed a program to help increase  opportunities for smaller asset management firms, including smaller  MWO firms.

Federal Reserve System. The Federal Reserve System’s Office of  Employee Benefits (OEB) has documented top leadership  commitment by developing policies that support the inclusion of MWO  firms in its asset manager searches. For example, OEB’s  procurement guidelines, which describe the process that staff should  follow when procuring goods and services, state that the office fully  supports equal opportunity in procurement. The guidelines also state  that prospective lists of vendors (including asset managers) to receive  requests for proposals should take into account OEB’s policy that  qualified firms interested in doing business with the office, including  minority- and women-owned businesses, should be included in the  candidate pool as appropriate. Additionally, in 2014 the Federal  Reserve System’s Committee on Investment Performance established  a policy requiring that each investment mandate for its two retirement  plans be reviewed at least every 5 years on a rolling basis, which has  provided additional opportunities to qualified MWO firms to compete  for all of OEB’s investment mandates on a regular basis.

The Federal Reserve System removed a potential barrier to MWO  firm participation by lowering its minimum requirement for assets  under management. According to Federal Reserve System  representatives, about 5 years ago OEB lowered the requirement  from $5 billion in assets under management to $1 billion in assets  under management for its defined benefit and defined contribution  plans. To conduct outreach, the Federal Reserve System has  participated in meetings and conferences organized by industry  associations that represent MWO firms and met with MWO firms  individually, according to Federal Reserve System representatives.  Federal Reserve System representatives have communicated their  priorities and expectations to investment staff by implementing  policies that have opened opportunities for MWO firms, as discussed  earlier. The entity has also tracked its use of MWO asset  management firms and the proposals it received from prospective  MWO asset managers.

Federal Reserve System officials told us that their efforts to increase  opportunities for MWO asset managers were primarily driven by two  factors. First, the decision was driven by a desire to find the best  managers in the industry. Second, officials stated that they were  aware of the issues surrounding the lack of inclusion in the asset  management industry and made changes to help address these  issues. Federal Reserve System officials noted that actively including  MWO asset management firms in their searches was consistent with  prudent investor requirements and fiduciary obligations. Officials also  noted that some potential benefits could be gained by a more  inclusive selection process, such as helping manage risk by  diversifying the portfolio and mitigating manager concentration risk  through new MWO managers.

Guaranty Corporation demonstrated top leadership commitment by  launching a Smaller Asset Managers pilot program in 2016. According  to the entity’s 2016 annual report, the program was created to reduce  barriers that smaller investment firms face when competing for the  agency’s business. As part of this program, the Pension Benefit  Guaranty Corporation removed a potential barrier to entry faced by  smaller firms by lowering its minimum requirement for assets under  management. Specifically, its minimum, which representatives told us  typically ranges from $10 billion to $50 billion, was lowered to $250  million for program applicants. All other asset manager selection  requirements, including performance, remained the same.

The Pension Benefit Guaranty Corporation conducted outreach to  smaller asset managers to promote its pilot program. For example,  the Pension Benefit Guaranty Corporation held a pre-bidding  conference designed to help applicants understand the selection  process. The entity also listed the request for proposal for its program  on the Federal Business Opportunities website and advertised the  program in industry publications. In addition, the Pension Benefit  Guaranty Corporation communicated its priorities and expectations  regarding its program to its consultant by requesting the consultant  help identify prospective MWO firms for the pilot program, according  to officials.

After completing the selection process for its pilot program, the  Pension Benefit Guaranty Corporation selected five firms to  participate. Of the five firms, four were minority- or women-owned  firms or both. Pension Benefit Guaranty Corporation officials stated  that, moving forward, they will evaluate the firms on their performance  against the portfolio benchmark over a full market cycle.

Smithsonian Institution. The Smithsonian Institution has  demonstrated top leadership commitment by revising its investment  guidelines and asset manager questionnaire to reflect its commitment  to diversity. Specifically, in March 2017 the Smithsonian Institution  revised its investment guidelines by adding “environmental, social,  and corporate governance considerations in the investment process”  as one of its selection criteria. According to Smithsonian Institution  representatives, this change allows the Smithsonian Institution to  incorporate diversity as additional criteria for asset manager selection.  The Smithsonian Institution also included a statement in its annual  asset manager questionnaire stating that its Office of Investments  strives to promote diversity and inclusion among its manager hires.  Furthermore, representatives stated that the Board of Regents and  Investment Committee encourage them to look broadly at portfolio  diversification not only in terms of asset classes and investment  strategies, but also of the racial and gender diversity of asset  managers. In addition, the Smithsonian Institution does not have  minimum size or length of track record requirements, which has  allowed smaller asset managers, including small MWO firms, to  compete for asset management opportunities with the endowment.

The Smithsonian Institution has also conducted outreach to MWO  firms. According to Smithsonian Institution representatives,  investment staff meet with MWO asset managers on an ongoing  basis. Staff have also participated in conferences focused on women- owned and emerging managers. Finally, the Smithsonian Institution  has communicated its priorities and expectations about inclusive  selection processes by asking its consultants for a list of diverse  managers, according to Smithsonian Institution representatives.  Representatives also told us that investment staff have been directed  to proactively identify MWO asset managers to add to this list based  on their capability and expertise.

Smithsonian Institution representatives told us they have often found  investing with smaller asset managers (including smaller MWO firms)  to be attractive to them. According to the Smithsonian Institution,  small firms tend to be entrepreneurial and entrepreneurial firms are  more successful when dealing with changing market dynamics, which  can increase the chances of delivering superior investment returns.  Representatives also noted that even though the endowment has a  small staff and limited resources, they have not found it difficult to  identify MWO asset managers for the endowment.

Three entities have used one or more of the practices, but have not fully  implemented all of them.

Army and Air Force Exchange Service. The Army and Air Force  Exchange Service has used two of the key practices we identified  (outreach and communicating priorities and expectations) and partially  used (has started but has not completed actions related to) the other  two practices (top leadership commitment and removing potential  barriers). Specifically, the Army and Air Force Exchange Service has  taken several steps to conduct outreach to MWO asset managers. For  example, representatives told us that they have held face-to-face  interviews with many MWO firms and gathered information on these  firms for potential future investments. Army and Air Force Exchange  Service representatives have also attended conferences and  networking events with MWO asset managers, directed these firms to  their consultant to learn more about the Army and Air Force Exchange  Service’s selection process, and accepted visitation requests from  MWO asset managers, according to representatives. The Army and  Air Force Exchange Service also has communicated its priorities and  expectations for a more inclusive asset manager selection process.  For example, the Army and Air Force Exchange Service has  instructed its investment staff to meet with representatives from MWO  trade groups. Additionally, the entity has requested that its consultant  include MWO asset managers who meet its portfolio needs in asset  manager searches.

However, the Army and Air Force Exchange Service has not  completed actions related to top leadership commitment and  removing potential barriers. According to representatives, plan  trustees have had initial discussions about taking additional steps to  increase opportunities for MWO firms at trustee meetings, but have  not taken actions related to these initial discussions. In addition,  representatives told us they use some fund-of-funds investments,  which have allowed smaller firms, including some MWO firms, to  compete for opportunities with the Army and Air Force Exchange  Service and have started to review their policies and practices to  include more participation of MWO firms in asset manager searches,  but have not completed this review as of June 2017.

Army and Air Force Exchange Service representatives told us they  consider the Army and Air Force Exchange Service to have used all of  the key practices we identified because they have taken at least some  action related to each of the practices. However, they did not have an  expected completion date for two of these actions.

Navy Exchange Service Command. The Navy Exchange Service  Command has used one key practice (removing potential barriers),  but has not used the other three practices (top leadership  commitment, outreach, and communicating priorities and  expectations). Specifically, the Navy Exchange Service Command  does not have minimum size or length of track record requirements for  its asset managers. According to officials, the Navy Exchange Service  Command does not use these two criteria to select asset managers in  part to help ensure asset manager searches are conducted as widely  as possible and include smaller asset managers, including smaller  MWO firms. However, the Navy Exchange Service Command has not  directly made efforts to reach out to MWO firms. Moreover, the entity  has not taken any actions to demonstrate top leadership commitment  and has not communicated its priorities and expectations to its  consultant because it has not specifically requested that its consultant  include qualified MWO asset managers in its searches for the Navy  Exchange Service Command.

According to Navy Exchange Service Command representatives, they  have not taken steps to implement all of the key practices because  they rely on their consultant to take these actions. Navy Exchange  Service Command representatives told us that their consultant is  committed to conducting inclusive asset manager searches for all of  its clients, performs outreach to MWO asset managers, and regularly  reports to the Navy Exchange Service Command on its outreach  efforts. Navy Exchange Service Command representatives also noted  that it may not be practical for the Navy Exchange Service Command  to directly conduct outreach to MWO firms because the entity is small  and its consultant has the resources and practices in place for  performing outreach to MWO firms. However, Navy Exchange Service  Command representatives have not specifically directed their  consultant to be more inclusive in their asset manager searches or to  conduct outreach.

Tennessee Valley Authority Retirement System. The Tennessee  Valley Authority Retirement System has used one key practice  (removing potential barriers). The entity does not have minimum size  or length of track record requirements, which can help widen the pool  of asset managers that the Tennessee Valley Authority Retirement  System considers for selection. However, the Tennessee Valley  Authority Retirement System has not used the other three practices  (top leadership commitment, outreach, and communicating priorities  and expectations).

According to Tennessee Valley Authority Retirement System  representatives, it is their understanding that their consultants  research and evaluate MWO asset managers and that to the extent  such firms meet selection criteria and rank high in the evaluation of a  particular investment mandate or strategy that the Tennessee Valley  Authority Retirement System is pursuing, the firms would be  considered for selection. Tennessee Valley Authority Retirement  System representatives also told us that limited staff and resources  make it difficult for them to conduct outreach to MWO firms. However,  the entity has not communicated its priorities or expectations to its  consultants because it has not directly requested or ensured that its  consultants include qualified MWO asset managers in searches  specifically conducted for the Tennessee Valley Authority Retirement  System, nor has the entity directed its consultants to conduct outreach  to MWO firms. Furthermore, the Tennessee Valley Authority  Retirement System has not taken any actions to demonstrate top  leadership commitment.

The Federal Retirement Thrift Investment Board has not used any of the  key practices. The board described a variety of reasons that have  prevented it from taking steps to increase opportunities for MWO asset  managers.

Federal Retirement Thrift Investment Board. According to Federal  Retirement Thrift Investment Board representatives, the Federal  Retirement Thrift Investment Board and Executive Director serve as  fiduciaries to Thrift Savings Plan participants and as such administer  the Thrift Savings Plan in the sole interest of participants and  beneficiaries. According to Federal Retirement Thrift Investment  Board representatives, the criteria used to select asset managers for  the Thrift Savings Plan funds include providing a passive index  strategy (as mandated by statute) and best value, which is a  combination of technical ability and low price. Representatives stated  that while qualified MWO firms are not restricted from responding to  their requests for proposals, given the size of Thrift Savings Plan  funds and the operational scale needed to manage a significant  amount of assets at a low cost, only a relatively small number of firms  respond.

Further, Federal Retirement Thrift Investment Board representatives  told us they plan to implement a mutual fund window platform for the  Thrift Savings Plan in 2020, and acknowledged that the platform could  provide an opportunity for MWO asset management firms. According  to plan representatives, they are seeking a platform that will provide  participants with a “broad array” of options, which they define as a  platform that includes a large number of mutual funds covering a wide  range of investment options. However, plan representatives told us  they do not plan to incorporate key practices into their selection  process when selecting a mutual fund platform.

According to Federal Retirement Thrift Investment Board  representatives, they are fiduciaries required to act solely in the best  interest of plan participants and beneficiaries and therefore cannot  make a decision based on criteria that favor any vendor or potential  vendor and cannot require that MWO firms be included in the  platform. As stated earlier, the key practices we identified can help  broaden the pool of qualified asset managers that investors can select  from, and do not mandate the hiring of MWO firms or sacrificing  performance standards. Moreover, other entities that have  implemented the key practices, including two that administer defined  contribution plans, have found that using inclusive selection practices  do not conflict with fiduciary obligations.

By fully implementing the key practices, the four entities could widen the  pool of potential candidates in their asset manager searches and help  ensure that they are finding the most qualified firms that meet their  investment needs. In keeping with federal interests, the practices could  also help address barriers MWO firms face and increase opportunities for  these firms.

section_title: Conclusions
paragraphs: Some of the federal entities we reviewed have taken steps to implement  more inclusive selection processes for asset managers, including  developing a pilot program for smaller asset managers and establishing  policies that support the inclusion of MWO firms in asset manager  searches. However, opportunities exist for other entities we reviewed to  take additional actions by implementing key practices. Specifically, the  Army and Air Force Exchange Service, Navy Exchange Service  Command, and Tennessee Valley Authority Retirement System have  used one or more of the key practices to increase opportunities for MWO  firms, but have not fully implemented all of them. The Federal Retirement  Thrift Investment Board has not used any of the key practices.  Implementing (or fully implementing) the key practices could widen the  pool of potential candidates in their asset manager searches and help  ensure that they are finding the most qualified firms that meet their or  their plan participants’ investment needs. Additionally, in keeping with  federal interests, if implemented, the practices could eliminate or mitigate  some of the barriers that MWO firms face and increase opportunities for  MWO firms.

section_title: Recommendations for Executive Action
paragraphs: We are making a total of four recommendations to four agencies:

The Chief Investment Officer of the Army and Air Force Exchange  Service should fully implement key practices to increase opportunities  for MWO asset managers as part of its selection processes.  Specifically, the Chief Investment Officer should complete actions  related to top leadership commitment and removing potential barriers.  (Recommendation 1)

The Chief Investment Officer of the Federal Retirement Thrift  Investment Board should use key practices as appropriate to increase  opportunities for MWO asset managers if and when implementing its  mutual fund window platform. Specifically, the Chief Investment  Officer should take actions to demonstrate top leadership  commitment, remove potential barriers, conduct outreach to MWO  firms, and communicate its priorities and expectations for an inclusive  selection process to its staff and consultants if and when it begins to  search for a mutual fund window platform. (Recommendation 2)

The Chief Investment Officer of the Navy Exchange Service  Command should fully implement key practices to increase  opportunities for MWO asset managers as part of its selection  processes. Specifically, the Chief Investment Officer should take  actions to demonstrate top leadership commitment, and to the extent  that staff and resources are a constraint, should direct its consultant to  conduct outreach to MWO firms and communicate its priorities and  expectations for an inclusive selection process by requesting its  consultant conduct more inclusive asset manager searches  specifically for the Navy Exchange Service Command.  (Recommendation 3)

The Chief Investment Officer of the Tennessee Valley Authority  Retirement System should fully implement key practices to increase  opportunities for MWO asset managers as part of its selection  processes. Specifically, the Chief Investment Officer should take  actions to demonstrate top leadership commitment, and to the extent  that staff and resources are a constraint, should direct its consultant to  conduct outreach to MWO firms and communicate its priorities and  expectations for an inclusive selection process by requesting its  consultant conduct more inclusive asset manager searches  specifically for the Tennessee Valley Authority Retirement System.  (Recommendation 4)

section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to the Army and Air Force Exchange  Service, Federal Reserve System, Federal Retirement Thrift Investment  Board, Railroad Retirement Board, Smithsonian Institution, Pension  Benefit Guaranty Corporation, Navy Exchange Service Command,  National Railroad Retirement Investment Trust, and Tennessee Valley  Authority Retirement System for review and comment. We received  written comments from the Army and Air Force Exchange Service,  Federal Retirement Thrift Investment Board, Navy Exchange Service  Command, and Tennessee Valley Authority Retirement System.

In their comments, reprinted in appendix IV, the Army and Air Force  Exchange Service and Navy Exchange Service Command agreed with  our recommendations. The Army and Air Force Exchange Service stated  that it would continue to press forward in implementing the key practices  to increase opportunities for MWO asset managers in a manner  consistent with its investment goals and guidelines. The Navy Exchange  Service Command stated that it will demonstrate top leadership  commitment by formally directing its consultant in writing to conduct  outreach to MWO firms on the entity’s behalf and communicate  expectations for an inclusive selection process for asset managers. The  Navy Exchange Service Command also provided technical comments,  which we incorporated as appropriate.

In its comments, reprinted in appendix V, the Federal Retirement Thrift  Investment Board disagreed with our recommendation. The Federal  Retirement Thrift Investment Board said that when developed, the  request for proposal for the mutual fund window will cover topics such as  information security and compatibility with the Thrift Savings Plan  recordkeeping software, and breadth of fund choices offered. The Federal  Retirement Thrift Investment Board stated that this will allow the Thrift  Savings Plan to offer participants that wish to use the mutual fund window  the greatest amount of choice in a secure, seamless, and efficient  manner. The Board also noted that fiduciary rules make it difficult to make  guarantees about any fund that might be offered in a future mutual fund  window. However, as we discuss in our report, implementing a more  inclusive selection process could bring in a broad array of asset  managers with different investment strategies and products that can help  the Federal Retirement Thrift Investment Board provide participants with  more investment options. Further, our recommendation would not require  the use of MWO asset managers in the mutual fund window, but instead  would help broaden the Federal Retirement Thrift Investment Board’s  selection processes and help ensure that qualified MWO firms are  considered. The Federal Retirement Thrift Investment Board also  provided technical comments, which we incorporated as appropriate.

In its comments, reprinted in appendix VI, the Tennessee Valley Authority  Retirement System agreed with our recommendation. The entity stated  that it was committed to a process with its consultants and asset  managers that provides equal opportunities for asset managers of all  types of ownership, including MWO firms. The entity also outlined actions  it would take to implement the key practices, such as documenting its  commitment to equal opportunity for all asset managers, including MWO  firms, in its investment policy statement and working with its consultant to  set up a process for providing the Tennessee Valley Authority Retirement  System information on potential MWO asset managers researched and  evaluated by its consultant.

The Federal Reserve System, Pension Benefit Guaranty Corporation, and  the Smithsonian Institution provided technical comments, which we  incorporated as appropriate. The National Railroad Retirement  Investment Trust and the Railroad Retirement Board informed us that  they had no comments.

As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to the agencies and other  interested parties. In addition, the report will be available at no charge on  the GAO website at http://www.gao.gov.

If you or your staff have any questions about this report, please contact  (202) 512-8678 or clementsm@gao.gov, or (202) 512-7215 or  jeszeckc@gao.gov. Contact points for our Offices of Congressional  Relations and Public Affairs may be found on the last page of this report.  GAO staff who made key contributions to this report are listed in appendix  VII.

section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: In this report we examined (1) the challenges minority- and women- owned (MWO) asset managers may face when competing for investment  opportunities, and practices used by selected state, local, and private  entities that administer or oversee retirement plans and foundations to  increase opportunities for MWO firms; (2) the major asset classes in  which selected federal entities invested, their use of MWO firms, and the  market presence of MWO firms in these asset classes; and (3) the  policies and processes selected federal entities use to identify and select  asset management firms, and their use of key practices to increase  opportunities for MWO firms.

We reviewed federal retirement plans, an endowment, and an insurance  program administered or overseen by eight entities (collectively referred  to as federal entities): Army and Air Force Exchange Service, Federal  Reserve System, Federal Retirement Thrift Investment Board, Railroad  Retirement Board, Smithsonian Institution, Pension Benefit Guaranty  Corporation, Navy Exchange Service Command, and Tennessee Valley  Authority. We selected the federal entities and the National Railroad  Retirement Investment Trust based on size (assets of more than $1 billion  in 2015) and investment strategies (passive or active management or  both). We excluded federal entities that solely invested in Treasury  securities that are not traded (and thus do not use external asset managers), such as the Civil Service Retirement System and the Federal  Employees Retirement System. These two retirement systems fund the  primary defined benefit pension benefits for the vast majority of federal  employees.
subsections: section_title: Objective 1: Challenges Faced by MWO Asset Managers
paragraphs: To identify challenges that MWO asset management firms face, we  analyzed reports by industry stakeholders, such as asset management  trade associations, institutional investors, and investment managers. We  also conducted interviews with asset management trade associations  (National Association of Investment Companies, National Association of  Securities Professionals, Association of Black Foundation Executives,  Association of Asian American Investment Managers, New America  Alliance, Private Equity Women’s Initiative, and Diverse Asset Managers  Initiative), 10 MWO asset managers, and 4 MWO brokerage firms.  These firms were selected based on size of the firms (assets under  management for asset managers and revenue for brokers), literature  reviews, and recommendations from industry stakeholders. Information  gathered from these interviews cannot be generalized to all MWO asset  managers or MWO brokerage firms.

To identify how entities that administer or oversee state, local, and private  retirement plans and foundations (nonfederal plans and foundations)  increase opportunities for MWO asset management firms, we interviewed  14 entities: California Public Employees’ Retirement System, California  State Teachers’ Retirement System, Employees’ Retirement Fund of the  City of Dallas, Exelon, Illinois Municipal Retirement Fund, Kellogg  Foundation, Knight Foundation, Maryland State Retirement and Pension  System, New York State Common Retirement Fund, Prudential’s  Strategic Investment Research Group, Silicon Valley Community  Foundation, Teachers’ Retirement System of Illinois, Teacher Retirement  System of Texas, and Verizon Investment Management Corp. Seven of  these entities administered defined benefit plans; three administered  defined benefit and defined contribution plans; three were foundations;  and one was an investment group. These entities were selected based on  size (assets), use of an MWO program or other initiative designed to  increase opportunities for MWO asset management, a literature review,  and recommendations by industry stakeholders. Information gathered  from these interviews cannot be generalized to all nonfederal plans and  foundations. We also analyzed reports by industry stakeholders on key  practices for MWO programs or similar initiatives. When relevant, we also  gathered information from these sources on the challenges faced by  MWO brokerage firms and practices used to increase their business  opportunities.

section_title: Objective 2: Asset Classes Invested in by Selected Federal Entities and Use of MWO Firms
paragraphs: To determine the major asset classes invested in by selected federal  entities and the National Railroad Retirement Investment Trust, we  obtained data from the entities and reviewed their annual reports and  audited financial statements for information on annual allocations made to  each asset class. Allocation data from annual reports and audited  financial statements reflect in some instances the investment objectives  of funds managed by external asset management firms, which may not  align precisely with the holdings of each fund. However, we concluded  these data were sufficiently reliable to document the asset classes in  which the federal entities we reviewed and the National Railroad  Retirement Investment Trust, invest.

To determine the presence of MWO firms in the same asset classes in  which the federal entities in our review and the National Railroad  Retirement Investment Trust invested, we reviewed publicly available  directories and databases of MWO asset managers compiled by industry  stakeholders and state retirement plans. We then reviewed the firms’  Form ADV filings in the Investment Adviser Public Disclosure database of  the Securities and Exchange Commission to identify the asset classes in  which they operate and the assets they reported managing. Finally, we  compared the total assets reported by MWO firms we identified to total  regulatory assets under management reported by all registered  investment advisers in the database as of May 2017. To assess the  reliability of data in the Securities and Exchange Commission database,  we identified and removed duplicate entries. We also checked data in the  database against the Form ADV filings of a random selection of firms to  ensure the database accurately reflects firms’ filings. Finally, we  compared total regulatory assets under management for all investment  advisers in the database to a July 2016 industry estimate of the global  asset management industry and found them to be similar. We also  compared the proportion of assets reported by the MWO firms we  identified to one calculated by researchers in May 2017 and also found  them to be similar. Although we did not independently verify the accuracy  of Form ADV filings, we concluded the data we obtained from them were  sufficiently reliable to estimate the proportion of regulatory assets under  management held by MWO asset managers.

To the extent available, we reviewed data on the percentage of each  federal entity’s and the National Railroad Retirement Investment Trust’s  asset managers that are minority- or women-owned, the percentage of  assets managed by these MWO firms, and the asset classes in which the  firms invested. To assess the reliability of these data, we interviewed  representatives of three federal entities and the National Railroad  Retirement Investment Trust with knowledge of the systems and methods  used to produce these data. We determined that the data we used were  sufficiently reliable for purposes of estimating federal entities’ and the  National Railroad Retirement Investment Trust’s use of MWO asset  managers in 2015 and 2016.

section_title: Objective 3: Asset Manager Selection Processes and Use of Key Practices
paragraphs: To determine the policies and processes that selected federal entities and  the National Railroad Retirement Investment Trust used to identify and  select asset managers and efforts to include MWO firms, we analyzed  investment policies; documentation on the processes and criteria used to  select asset managers, including internal guidelines and examples of  requests for proposals for investment management services; and  available documentation on programs, policies, or initiatives related to  MWO firms. In addition, we interviewed representatives from the entities  we reviewed to learn more about their selection processes and efforts  related to MWO asset managers.

We assessed the extent to which federal entities used key practices to  increase opportunities for MWO firms. Specifically, we identified key  practices by examining the practices used by nonfederal plans and  foundations and by reviewing industry reports. We then validated the  practices by obtaining input from 10 industry stakeholders and experts  selected based on factors such as depth of experience working with  MWO firms and published research. The stakeholders and experts  generally agreed with the practices we identified, but one expressed a  concern about implementing two of the practices. We then assessed the  extent to which the federal entities we reviewed used each key practice  using three categories. “Uses” indicates that the entity completed an  action or actions to implement the practice; “partially uses” indicates that  the entity has started an action or actions to implement the practice, but  has not completed the action(s); and “does not use,” which indicates that  the entity has not started or completed any action(s) to implement the  practice. One analyst reviewed the entities’ policies and practices and  made the initial assessment. A second analyst then verified these steps  to ensure consistent results.

We conducted this performance audit from April 2016 to September 2017  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.

section_title: Appendix II: National Railroad Retirement Investment Trust
paragraphs: Representatives from the National Railroad Retirement Investment Trust  (Trust) stated that trustees and investment staff have a fiduciary  obligation to invest the Trust’s assets solely in the best interest of the  Trust and its beneficiaries. Representatives told us they do not believe  their asset manager selection process, described below, has precluded  the Trust from hiring smaller or minority- and women-owned (MWO) firms.

Selection criteria and process. According to Trust representatives,  the Trust does not have minimum size or length of track record  requirements for its asset managers, but considers an asset  manager’s size, as well as the appropriate size of a possible  allocation to the manager, when determining whether to hire the  manger. They also stated that it was important to hire managers that  have a demonstrable history of successfully investing and that  generally, track records that cover longer time periods are more  statistically significant than shorter-term track records because there  are more data points to analyze. Trust representatives emphasized  that considering these factors has not prevented the Trust from hiring  smaller firms, and that about half of their asset managers are small to  mid-size firms.

According to Trust representatives, the Federal Acquisition Regulation  does not apply to the Trust’s asset manager selection process. The  Trust uses internal investment staff to identify potential asset  managers. Trust representatives told us that searches for asset  managers in the public markets (for example, publicly traded stocks  and bonds) typically occur when an asset manager needs to be  replaced (due to a variety of reasons, such as personnel changes),  whereas searches for asset managers in private markets (for  example, alternative assets such as private equity and real estate)  occur on an ongoing basis.

Use of Consultants. Trust representatives told us that they do not  use consultants; rather, in-house investment staff conduct the  research and evaluation process. Generally, investment staff identify  potential asset managers by researching commercial or internally  developed databases and then conduct an internal review, which  includes reviewing information on prospective firms’ investment  strategies and meeting with the firms. Investment staff subsequently  develop a memorandum on the prospective asset managers and  conduct a final internal analysis before recommending asset  managers to trustees, who approve all final selections and the amount  of the planned investment.

Key Practices. According to Trust representatives, the Trust has  taken steps to increase opportunities for MWO firms. Specifically, the  Trust’s board has discussed the Trust’s selection practices as they  relate to MWO firms on an ongoing basis during its quarterly meetings  and has analyzed its use of MWO firms. In addition, Trust  representatives told us they conducted outreach by meeting with trade  associations representing MWO firms. Further, according to Trust  representatives, the Trust does not have minimum size or length of  track record requirements for its asset managers, which has removed  potential barriers to smaller firms, including smaller MWO firms.  Finally, according to Trust representatives, the Trust has tentatively  approved revisions to its investment procedures manual that would  incorporate statements about valuing diversity and having an inclusive  asset manager selection process. Trust representatives told us that  the Trust’s board intends to formally approve the revisions at its  upcoming board meeting.

section_title: Appendix III: Minority- and Women-Owned Brokerage Firms
paragraphs: The federal entities we reviewed and the National Railroad Retirement  Investment Trust do not directly hire brokerage firms. However, in  conducting our work on nonfederal plans, we identified challenges  minority- and women-owned (MWO) brokerage firms face that may limit  them from fully competing for opportunities with institutional investors,  including retirement plans and foundations, and the asset managers  these entities use.

Brand bias. According to two MWO brokerage firms with which we  spoke, MWO brokers may have difficulty competing with larger  brokerage firms that are well known in the industry and have long- standing relationships with asset managers.

Size. One brokerage firm with which we spoke noted that some  institutional investors and asset managers may have the  misconception that smaller broker dealers cannot execute trades as  effectively as large brokerage firms, and that using MWO brokers will  cost more. Another brokerage firm told us that net capital thresholds  were too high for newer, smaller MWO brokers to meet. As a result,  MWO brokers may have greater difficulty competing for opportunities.

Track record. Shorter track records are also a hindrance, according  to brokerage firms we interviewed. For example, one brokerage firm  noted that although most brokers may have worked with large  corporations before starting their own companies, they may not get  the credit for the experience they have because they are a new firm.  As a result, they may be overlooked when investors search for  brokerage firms.

Some state, local, and private plans have taken actions to address these  challenges and increase opportunities for MWO brokerage firms.

Communicate expectations. Two nonfederal plans and one  foundation we interviewed directed their asset managers to use more  inclusive practices for sourcing and hiring qualified MWO brokerage  firms.

Conduct outreach. A state plan also directly communicated with  MWO brokerage firms at networking events, and directed its asset  managers to do so as well.

Report usage of MWO brokers. Some state and local retirement  plans have legislative mandates to promote the use of MWO firms,  including brokers, and require that their asset managers report on  their use of MWO brokerage firms. For example, a local plan in Illinois  sets MWO broker-dealer utilization percentage goals across asset  classes for its asset managers, and requires that asset managers  report monthly on MWO broker utilization.

section_title: Appendix IV: Comments from Army and Air Force Exchange Service and Navy Exchange Service Command

section_title: Appendix V: Comments from Federal Retirement Thrift Investment Board

section_title: Appendix VI: Comments from Tennessee Valley Authority Retirement System

section_title: Appendix VII: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contacts

section_title: Staff Acknowledgments
paragraphs: In addition to the contacts named above, Kay Kuhlman (Assistant  Director), Kimberley Granger (Assistant Director), Erika Navarro (Analyst  in Charge), Farah Angersola, Bethany Benitez, Raheem Hanifa, John  Karikari, Risto Laboski, Jill Lacey, Marc Molino, Tom Moscovitch, Barbara  Roesmann, Adam Wendel, and Amber Yancey-Carroll made key  contributions to this report.


Question-summary annotations: questions: question: What challenges do MWO asset managers face when competing for investment management opportunities?
answer: According to asset managers and industry associations with which GAO spoke, minority- and women-owned (MWO) asset managers face challenges when competing for investment management opportunities with institutional investors, such as retirement plans and foundations.
child_questions: question: What is a common preference among institutional investors?
answer: For example, institutional investors and their consultants often prefer to contract with large asset managers with brand recognition and with whom they are familiar.

question: How does business size affect MWO contracting bids?
answer: Also, small firms, including MWO firms, are often unable to meet minimum requirements set by institutional investors, such as size (assets under management) and past experience (length of track record).

question: How are some investors attempting to mitigate this issue?
answer: State, local, and private retirement plans and foundations GAO interviewed addressed these challenges in a variety of ways, such as asking their consultants to include MWO firms in their searches. Many plans also lowered their minimum threshold requirements so that the requirements were proportional to the size of the firms while maintaining the same performance requirements for all asset managers in their selection processes.

questions: question: How much money is managed by United States asset management firms?
answer: Asset management firms registered in the United States manage more than $70 trillion.
child_questions: question: How does this compare to the money managed by MWO firms?
answer: MWO firms manage less than 1 percent of those assets.

question: Why is this important to the federal government?
answer: The federal government has an interest in increasing opportunities for MWO businesses.

question: What was GAO asked to examine?
answer: GAO was asked to examine, among other things, (1) competitive challenges MWO firms face and how institutional investors address them, (2) selected federal entities' use of MWO firms, and (3) the entities' asset manager selection processes, including their use of key practices.

question: How did GAO source their data for this review?
answer: GAO reviewed investment policies and financial statements of 8 entities that manage or sponsor federal retirement plans, an endowment, and an insurance program. GAO also interviewed 14 state, local, and private retirement plans and foundations and 10 MWO asset managers (selected based on size and other factors).

questions: question: What did GAO's report conclude regarding MWO firms?
answer: GAO makes four recommendations to increase opportunities for MWO firms, in keeping with federal interests.
child_questions: question: How many federal entities do these suggestions affect?
answer: Four federal entities should use key practices, as appropriate.

question: To what extent did federal entities agree with the recommendations?
answer: The Army and Air Force Exchange Service, Navy Exchange Service Command, and Tennessee Valley Authority Retirement System agreed. The Federal Retirement Thrift Investment Board disagreed.

question: To what extent does GAO support the conclusion of the report?
answer: GAO maintains that key practices should be used, as discussed in the report.