One of the more welcome aspects of the Financial Conduct Authority’s recent announcement to review the value provided by UK asset managers is that the study will include the role of investment consultants.
These intermediaries are typically employed by public and corporate pension funds, charities, universities and so on, to advise them on their investments. But consultants generally do more harm than good, for three main reasons.
No Competition And Misaligned Interests
First, in the UK at least, investment consulting is not a competitive industry. There are three dominant firms, and the six largest consultancies have a 70 percent market share. According to KPMG, three-quarters of contracts are awarded without a competitive tender. Consequently, the fees consultants command have a considerable impact on net returns.
Secondly, investment consultancy is riddled with conflicts of interest. Consultants are increasingly using their position to pitch their own asset management services to clients. In those circumstances, it is surely impossible to give genuinely independent and unbiased advice.
But the third and most important reason why consultants typically extract value rather than add it is that, as the evidence clearly shows, the investment recommendations they make tend to produce worse, not better, performance.
Consultants Can’t Pick Good Managers
A 2013 study by Saïd Business School at the University of Oxford, Picking winners? Investment consultants' recommendations of fund managers, analysed the aggregate recommendations of consultants with a share of more than 90 percent of the U.S. market, between 1999 and 2011. On an equally-weighted basis, the average returns delivered by the products consultants recommended were around 1 percent lower than those of other products.
So, why should that be? Why should paying for expertise produce inferior results? One explanation is that identifying future outperformers is extremely difficult. Another is that, although consultants consider a range of factors when recommending funds, they nevertheless attach considerable weight to how funds have performed in the recent past. Investment consultants, of all people, should know that picking a fund because it’s had a good run is not a sensible thing to do.
A 2008 study entitled The Selection and Termination of Investment Management Firms by Plan Sponsors, found clear evidence of performance chasing by consultants. The researchers, from the University of Arizona, analysed the hiring and firing of managers by around 3,700 plan sponsors in the US between 1994 and 2003. In the three years before being recruited, the hired managers had outperformed their benchmarks by an average of 2.91 percent; but in the three years after they were hired they underperformed their benchmarks by 0.47 percent a year. To add insult to injury, the study found, the managers who were fired actually produced better returns than those who were hired.
It’s Nice To Pass The Buck
All this begs the question, Why do pension funds employ investment consultants at all? I certainly agree with the author Larry Swedroe that there is an element of “CYB, or cover your behind — providing someone other than themselves to blame if things go wrong”.
But there is another, more charitable, explanation. Fund trustees don’t just hire consultants to recommend which funds to use. Other services consultants provide include strategic asset allocation, benchmark selection and performance monitoring — all of which are valuable.
Investment consultants do, therefore, have an important part to play, but it has little to do with spotting talented managers or market timing. It’s more about educating fund trustees on how the capital markets work, recognising their biases and managing their behaviour; it’s about helping them to spread their risk and to capture market returns as cheaply and efficiently as possible.
Nor should investment consultants be doing things just for the sake of it. As the chief investment officer of a big UK pension fund recently told the Financial Times, “many consultants feel obliged to recommend change to justify their fee, when, in fact, no change would be better.”
Consultancy Empire Remains Strong
Whether the FCA study succeeds in making investment consulting more competitive, relevant or effective remains to be seen. There are powerful vested interests which benefit from the status quo and will doubtless lobby hard over the coming months. These include the consultancy firms themselves, of course, but also the fund industry.
It was no surprise when, responding to the announcement of the FCA study, Guy Sears, the Interim CEO of the Investment Association, referred to the “critical rôle” consultants play in delivering the best outcomes for clients. The industry wants us to think that consultants are critical because active fund management is fundamentally about skill. The inconvenient truth it doesn’t want fund trustees or any other investors to hear is that it’s largely a matter of luck; that no more managers consistently outperform the market than you would expect from random chance.
Yes, investment consulting does have a role — but not the one that most consultants, or the Investment Association, like to think it is.
Robin Powell is a journalist campaigning for a better deal for ordinary investors. He blogs as The Evidence-Based Investor.
[This article was first published on Powell’s blog and has been reposted here with permission]