Regular readers of this blog will know we have pretty strong opinions on how advisers don’t add value. Advisers who still claim to be able to beat the market by consistently picking the right fund managers and timing the market are deceiving themselves, their clients or both.
So how do advisers add value? The main way they do it is by helping the client to establish his or her priorities and goals, devising a plan to ensure that they receive they goals, and helping the client to stick to the plan through thick and thin.
But there is a bigger picture, of which the plan, and sticking to the plan, are just a part. Ben Carlson, from Manhattan-based Ritholtz Wealth Management, has done an excellent job of painting that bigger picture with is new book Organizational Alpha. It’s an excellent read for advisers and investment consultants, and also for fund trustees.
Thank you to Ben for giving us this highly informative and insightful interview.
What exactly do you mean by organizational alpha?
The entire organizational structure wrapped around a fund or investment portfolio can actually become a source of alpha when investors are able to focus on improving their decision-making process, planning, philosophy, and culture. Institutions and individuals alike can improve their performance by optimizing how they operate.
What was your motivation in writing the book?
The largest pensions and endowments get all of the press but there are tens of thousands of smaller and mid-sized nonprofit institutions out there who don't have the same level of expertise, investment staff or financial resources. This book was meant to help these organizations make better decisions that can align their portfolios with their stated missions. There are a lot of organizations out there who are trying to do good things with their money but many of them aren't getting great financial or investment advice. I'm trying to provide these funds a framework to make more informed decisions.
You particularly focus in your own work on institutional investors, pension funds and so on. What are the biggest mistakes, in your experience, that fund trustees make?
Institutional investors make similar mistakes as regular investors -- they chase past performance, get caught up in fad investments and too often make short-term decisions with long-term capital. But the reasons for these mistakes tend to be different in the institutional space. Career risk is a huge reason for many of these mistakes. The boards of these funds are often filled with people who don't have a ton of investment background and that can lead to sub-optimal results when combined with poor advice from the financial sector. And the group dynamic at play between board members, the investment committee, investment consultants, donors and money managers can make it difficult to make rational decisions.
What is the actual evidence on the efficacy (or otherwise) of investment consultants?
A number of studies have shown that investment consultants add no value through their selection of money managers on behalf of institutional funds. In fact, the data shows that the managers or funds that they get rid of go on to outperform the new ones they bring in on a consistent basis. These consultants are usually hired specifically to pick the top-performing money managers, but we all know that this is easier said than done. The career risk factor here makes it very difficult to stick with any manager or fund that is struggling so there ends up being constant changes to these portfolios.
If the record of investment consultants is so poor, why do you think trustees keep hiring them?
There's a lot of inertia in this industry. This is the way things have always been done so it can be difficult to get all parties involved to make legitimate changes to the standard way of doing things. There's also an element of scapegoating where it can be nice to have consultants around to blame if things go wrong with the performance of the fund. There are also very few alternatives out there to the way things are currently being run. Most trustees have never seen a presentation that shows them why the current form of consultancy doesn't work very well so they move from consultant to consultant in hopes of striking it rich.
You’re based in the US, but you explain in the book that this is a more global problem, don’t you?
That's correct. In the US, the 10 largest consultants have over an 80% share of the institutional marketplace. In the UK, the top 6 consultants control 70% of that space and worldwide the top 10 consulting firms control 82% of the market. The problem with this type of scale is that you tend to see the herd mentality in the portfolio decisions that are being made. Since it's been shown that these consultants use the best performing funds in the past, that means a very large number of clients are chasing past performance. Plus, at that size, it's very difficult for these large consulting firms to provide personalized advice to their clients.
Nevertheless you still think there is sill a place for investment consultants. In what ways do you think a consultant can add value in the institutional space?
Yes, I believe consultants can add value. They just need to focus their attention beyond money manager selection. Things like client education and communication, behavioral management and modification, setting realistic expectations, documenting the investment process, explaining the investment process in plain English and generally making the trustees' lives easier.
What can trustees do, when hiring consultants, to ensure that they’re getting value for money?
Trustees need to go into the process with realistic expectations about what a good consultant can and cannot do for them. They need to ask the right questions. And they need to define everyone's role upfront in terms of what a successful relationship would look like going forward. Some underrated variables in a great consulting firm are honesty and transparency, the ability to educate and communicate effectively, an intense focus on the goals and mission of the organization in question and the ability to improve the decision-making process through their recommendations and behavioral coaching.
What specific steps have you at Ritholtz Wealth Management, as a company, to ensure that you’re delivering organizational alpha?
Our investment philosophy can be summarized as less is more, costs matter, forecasts are unreliable and performance is mean-reverting. We also believe that philosophy is universal but the strategy has to be personal. Asset management without goals is like trying to construct a building without blueprints. Financial advice and investment management have to be attached at the hip. We document the entire investment process and periodically reassess to ensure everything is still on track and figure out if any changes are necessary. We're committed to transparency and communication with our clients to ensure they know what we're doing and why we're doing it. Our investment philosophy is evidence-based but we also recognize that real-life experiences don't play out like they do in a simulation. So we are very aware of the behavioral aspects of investing and the challenges that it involves. The best portfolio strategy in the world won't work if your clients can't stick with it. We also have monthly investment committee meetings to go over all of our portfolios and ensure the checks and balances we have in place are still valid. We practice a rules-based approach to investing to keep our emotions out of the process. Many advisors talk about client emotions but very few are able to look themselves in the mirror to keep their own blindspots in check. We also believe in setting reasonable expectations and being open and honest about any potential drawbacks of our strategies.
What advice would you give to other advisory firms who are looking to learn from what you’ve achieved at Ritholtz WM?
There's a lot to be said for choosing the right people. This applies to who you work for and who you work with. Finding a firm that aligns with my personal values has been very enriching for me because I tend to think that principles are very important. But this also translates to the clients you work with. Client fit is everything to us from a business and personal perspective because we want to work with the right clients. It makes our lives easier and by avoiding clients who are a bad fit, we're able to pay more attention to our current client base and give them the attention they deserve. This mindset also aligns with our investment philosophy which eschews short-term oriented decisions and focuses on the long-term.
If you enjoyed this article, you might also like to take a look at this interview with Ben for our sister blog The Evidence-Based Investor on the value of simplicity:
Complex markets don’t require complex solutions — Ben Carlson