The latest academic study on investment consultancy makes pretty grim reading for anyone working in it. It also raises serious issues for fund trustees who pay consultants for advice, which happens to be the vast majority of them.
The paper, Investment Consultants’ Claims About Their Own Performance: What Lies Beneath?, published in July, is authored by Tim Jenkinson and Howard Jones from the University of Oxford’s Saïd Business School, Jose Vicente Martinez of the University of Connecticut and Gordon Cookson from the UK regulator, the Financial Conduct Authority.
The problem, the authors found, is that consultants don’t actually do what they say they can do. To quote the report, they “market their services by claiming that their fund manager recommendations add significant value. Using detailed data from the leading investment consultants we find no such evidence.”
Jenkinson et al. looked at the performance of funds recommended by investment consultants between 2006 and 2015. Once fees were factored in, they discovered, the funds that consultants didn’t recommend subsequently delivered better performance than those they did recommend.
The researchers also found that funds recommended by consultants were less likely to deviate from the index. As anyone who knows anything about fund performance will appreciate, it’s very difficult for any fund to outperform the market consistently; for a fund that closely resembles the index, it’s almost impossible.
Perhaps most worrying of all, the study shows that the big consultancy firms significantly exaggerate the performance they’ve achieved in the past. To quote the report again, “the weighted average of (consultants’) claimed excess returns of 1.73% per year exceeds our estimation of their performance by 1.94% or 1.95% per year.”
Unfortunately, these latest findings are in line with previous studies, notably the 2008 study by Amit Goyal and Sunil Wahal, The Selection and termination of investment Management Firms by Plan Sponsors. They too found that, net of costs, the fund managers fired on the advice of consultants went on to outperform the managers who were hired.
What, then, does all this mean for investment consultancy? Given their fiduciary duty, is there a case for pension funds, charitable trusts and so on dispensing with the services of consultants altogether?
I must say I’m extremely sceptical about the use of investment consultants, and trustees need to be certain that they’re receiving good advice and value for money. I do, however, still believe that there is a valuable role for consultants to play.
The first thing that trustees have to do is to decide why they’re hiring consultants in the first place. There is no doubt that, as things stand, most consultants are hired, first and foremost, to recommend funds to invest in.
In a study entitled Institutional Investor Expectations, Manager Performance and Fund Flows, Jones and Martinez found that “those responsible for the selection decisions (i.e. the trustees) sought primarily to minimise the risk of losing their jobs by choosing managers who had been demonstrably successful in the past.”
Trustees need to acknowledge the empirical evidence that consultants cannot identify winning fund managers in advance. Paying them in the hope that they will do so isn’t only pointless; it extracts value and reduces the net return.
So, what can consultants provide that does add value? Initially there are four things they can be of genuine assistance. They can:
— educate their clients and set realistic expectations about likely outcomes;
— identify the asset allocation that most accurately reflects the organisation’s risk capacity and time horizon;
— build a suitable portfolio, remembering Warren Buffett’s advice that “both large and small investors should stick with low-cost index funds”;
— ensure that short-term liquidity needs can always be met by setting appropriate guidelines for cash management; and
— set up automatic rebalancing so that the original asset allocation is restored, either every year or when pre-established perimeter thresholds are breached.
Essentially, though, all of those things can be done at the outset. What need is there for trustees to retain the services of a consultancy firm over the long term?
Well, this may may seem obvious, but something else that trustees need to acknowledge is that consultants want to earn recurring fees. They have a vested interest in appearing to be active and in tweaking their recommendations from year to year. “The consequence of this activity,” in the words of Goyal and Wahal, “is a constant churn of hires and fires that, by any easily measurable metric, adds no value.”
Almost invariably, assuming they have the right plan in place, the best advice for trustees is to do precisely nothing, and to leave their portfolio as it is. Why, then, you might be wondering, would you want to pay a consultant to meet you each year, simply to tell you to not to do anything? Indeed, you would have a point.
A cheaper and more sensible option would be for trustees to hire the same consultants again on a purely ad hoc basis, to educate new trustees, manage behaviour and provide reassurance that, in the absence of any crystal balls, there is no need to change the course that’s already been set.
Again, there’s a paradox here that trustees need to get their head around — the paradox of expertise. It was neatly encapsulated the other day by the Wall Street Journal’s Jason Zweig. “The broader and deeper your knowledge,” says Jason, “the more readily you will say ‘I don’t know’, thereby convincing the typical person that your knowledge is narrow and shallow.”
Investment consultants who say “I don’t know” are, paradoxically, the ones worth paying for.
If you’re a fund trustee yourself, you may in interested to know that I’m going to be addressing all of these issues in two breakfast seminars, entitled Evidence-Based Investing for Trustees. I’m organising the events , in conjunction with the Cheltenham-based financial planning firm RockWealth.
The first seminar is in Cheltenham on Wednesday 3rd October, and the second in London on Wednesday 17th October. Among the other speakers will be Charles Payne, a former director of Fidelity, and the hedge fund manager turned indexing advocate Lars Kroijer.
Trustees of pension and investment funds of all kinds are welcome to come., and attendance is free. However, places at both events are strictly limited, so if you’d like to attend I suggest you email Sarah Horrocks at RockWealth as soon as possible at firstname.lastname@example.org.