Swedroe: Institutional Investing Money Pit

August 27, 2018

Institutional investors often hire investment consultants to provide recommendations on fund managers. Because the investment consulting industry had assets under advisement of about $38 trillion as of 2017, institutional investors must believe their recommendations add value. But do they?

To help answer that question, I’ll review some of the findings from academic research.

The Evidence

The 2007 study “The Performance of U.S. Pension Funds: New Insights into the Agency Cost Debate,” by Rob Bauer, Rik Frehen, Hubert Lum and Roger Otten, covered 716 defined benefit plans from 1992 through 2004 and 238 defined contribution plans from 1997 through 2004. The authors found their returns relative to benchmarks were close to zero. They also found there was no persistence in pension plan performance.

Thus, despite the conventional wisdom, past performance is not a reliable predictor of future performance. Importantly, they also found that fund size, degree of outsourcing, and company stock holdings were not factors driving performance. This finding refutes the claim that large pension plans are handicapped by their size—small plans did no better.

The authors concluded: “The striking similarities in performance patterns over time makes skill differences highly unlikely.”

Counterproductive Activity

The study “The Selection and Termination of Investment Management Firms by Plan Sponsors,” by Amit Goyal and Sunil Wahal, which appeared in the August 2008 issue of the Journal of Finance, provides further evidence on the inability of plan sponsors to identify investment management firms that will outperform the market after they are hired.

Goyal and Wahal built a data set of the hiring and firing decisions by approximately 3,700 plan sponsors (public and corporate pension plans, unions, foundations and endowments) from 1994 to 2003. The data represented the allocation of more than $737 billion in mandates to hired investment managers and the withdrawal of $117 billion from fired investment managers.

Following is a summary of their findings:

  • Plan sponsors hire investment managers after large, positive excess returns up to three years prior to hiring.
  • Their return-chasing behavior does not deliver positive excess returns thereafter.
  • Post-hiring excess returns are indistinguishable from zero.
  • Plan sponsors terminate investment managers after underperformance, but the excess returns of these managers after being fired are frequently positive.
  • If plan sponsors had stayed with the fired investment managers, their returns would have been larger than those actually delivered by the newly hired managers.

Cost Of Change

It is important to note that the preceding results did not include any of the trading costs that would have accompanied transitioning a portfolio from one manager’s holdings to the holdings preferred by the new manager. In other words, all of the firing and hiring activity was counterproductive.

Howard Jones and Jose Vicente Martinez came to basically the same conclusions in the study “Institutional Investor Expectations, Manager Performance, and Fund Flows,” which was published in the December 2017 issue of the Journal of Financial and Quantitative Analysis.

Using 13 years of survey data from Greenwich Associates covering plan sponsors with half of the institutional holdings in U.S. equities, they established a measure of the future performance that plan sponsors expect from their asset managers.

Added Value Not Adding Up

Jones and Martinez found that while fund flows correlate highly with past performance, there is no evidence consultants’ recommendations add value for the institutional investors that follow them.

They concluded: “Institutional investors allocate funds mainly on the basis of fund managers’ past performance and of investment consultants’ recommendations, but not because they extrapolate their expectations from these. This suggests that institutional investors base their investment decisions on the most defensible variables at their disposal and supports the existence of agency considerations in their decision making.”

Agency Problem

Jones and Martinez explain: “Those responsible for the selection decisions sought primarily to minimize the risk of losing their jobs by choosing managers who had been demonstrably successful [at beating a benchmark] in the past.”

This creates an “agency” problem (a conflict of interest). The authors also highlight another agency issue, specifically, the need to appear active.

They write: “If fund selectors do not select funds, what are they to do? The consequence of this activity is a constant churn of hires and fires that, by any easily measurable metric, adds no value, but nonetheless necessitates the continuous establishment of new business relationships.”

Veracity Of Consultants’ Claims

A more recent contribution to the literature on the value that investment consultants provide comes from Gordon Cookson, Tim Jenkinson, Jones and Martinez, authors of the July 2018 study “Investment Consultants’ Claims About Their Own Performance: What Lies Beneath?” The authors compared the value added by consultants’ recommendations with the claims consultants make about themselves.

Their analysis is based on a unique data set sourced by a U.K. regulator, the Financial Conduct Authority, which provided detailed records of the institutional asset managers recommended by each of six leading investment consultants between 2006 and 2015. This permitted the authors to identify, for each consultant, when an investment product was first recommended and the period for which it remained so.

Reliable Guides To Past Performance?

The six consultants in the sample include three of the largest firms worldwide, with combined market shares of about 45%. Each of these three large consultants also produces an analysis of their own performance and the products they recommend, to which the authors had access.

This allowed Cookson, Jenkinson, Jones and Martinez to determine if the disclosures that consultants present to institutional investors are reliable guides to their past performance.

The study’s second data source is eVestment, a data provider to the asset management industry that collates information self-reported from institutional asset managers. Those asset managers had aggregate assets under management at year-end 2015 of more than $37 trillion.

Before reviewing the authors’ findings, it’s important to observe that the weighted average excess returns over benchmarks claimed by the three consultants for the products they recommend was 1.7%. All three consultants claimed significant excess returns, but each uses a different methodology and did not make the underlying data available, so that institutional investors must take on trust the basis for and comparability of these claims.

Authors’ Findings

  • Consultants’ average annual fees to asset owners for advisory services (which are not limited to providing asset manager recommendations) range from 0.09% for assets under management of less than $70 million to 0.02% for assets under management of about $1 billion.
  • On average, consultant-recommended investment products perform no better than other products available to institutional investors.
  • The portfolio of all products recommended by investment consultants delivered average returns gross of management fees 0.30% per year lower than returns earned by other products available to plan sponsors but not recommended by consultants.
  • When comparing recommended products to a matched sample of nonrecommended products in the same investment category, the recommended products still trailed nonrecommended products by 0.21% per year (or by 0.23% per year after management fees). These differences are not statistically significant.
  • The results are robust to a number of variations in the analysis. These include using a larger sample of consultants, assuming fixed holding periods for products recommended by plan sponsors, and considering negative recommendations.
  • There are no consistent differences between recommended and nonrecommended products in terms of return volatility or betas with respect to manager-chosen benchmarks. This, in turn, suggests there are no significant differences in total and systematic factor risk between the two sets of products or any significant differences in leverage.
  • Recommended managers, on average, deviate less from their benchmarks than nonrecommended ones—perhaps explaining why they are recommended. Yet hugging a benchmark increases the hurdle for active managers, making it less likely they will outperform.

There are large differences between the claims made by the three large consultants in the data set and the independent analysis of their performance. Specifically, their claims were exaggerated by close to 2% per year.

No Systematic Skills

Cookson, Jenkinson, Jones and Martinez concluded: “In aggregate returns, investment consultants appear, on average, to have no systematic skills in manager selection.” They added: “Our analysis suggests that consultants’ claimed performance is not just wide of the mark, but also that their disclosures are poor guides to their relative performance.” They went on to state: “Investment consultants tend to overstate their ability to select fund managers.”

Among the causes the authors supplied for these exaggerated claims were:

  • Consultants typically retain simulated and back-filled returns in their performance analysis, which potentially generate an upward bias in the product returns sample and excess returns over benchmarks.
  • Some consultants employ restrictions in drawing up the sample they use when assessing their own performance, leading to survivorship bias in the results. For instance, they may require the recommended product to remain on their recommendation lists for a certain number of full years.
  • Some consultants tailor the sample they use in their analysis in a way that appears largely arbitrary except insofar that it opens a further gap between their analysis and the authors’ calculations. For example, they might exclude certain individual investment products or categories of products.
  • Consultants may compare recommended products to benchmarks rather than to other products available in the same investment category.

Hard To Measure Consultants

The authors noted: “The distortions generated by these practices—which vary between consultants—means that institutional investors face an almost impossible task in assessing not just the absolute, but also the relative performance of investment consultants.”

Following is a simple example of how a manager’s choice of benchmark can provide misleading information.

Due to the transparency of its reconstitution rules, active managers could choose to front-run the Russell 2000 Index. That created a performance drag for funds seeking to match it. This is why Vanguard eventually abandoned that index as the benchmark for its Small Cap Index Fund (NAESX). From January 1979 through June 2018, the Russell 2000 Index returned 11.8%, while the very similar CRSP 6-10 (small-cap) Index returned 13.1%. Those results show an underperformance of 1.3% per year, perhaps explaining why funds and investment consultants would choose the Russell 2000 as a benchmark.

Summary

Despite their wide use, evidence is lacking that investment consultants add value in terms of their ability to select actively managed funds.

That raises the question of why institutional investors continue to engage them in this endeavor. The answer likely can be found in the aforementioned agency issues; employees need to appear active, and they need someone to blame when a strategy fails.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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