The advent of investment consultants into fiduciary management raised some concerns, not least over conflicts of interest. The proliferation of descriptive titles for these activities also raised concerns, as in addition to the possibility of finer distinction, this practice also serves to obscure. It reduces the fiduciary management classification to a fuzzy, ill-defined set.
One of the key points in the sales pitches for fiduciary management was that this delegation of powers would enable faster decision-making and the exploitation of rapidly passing opportunities in markets. No mention here of ‘marry in haste, repent at leisure’, which does have academic support. No mention either that such transient “opportunities” are speculations rather than investment; but , perhaps more importantly, no evidence has been offered that this short-term speculative behaviour can be achieved and aggregated to deliver superior long-term returns.
The recently published JJM Study (Jenkinson, Jones & Martinez 2014) casts serious doubt on the ability of investment consultants to select managers. Of course, the fiduciary problem is somewhat different – here the selection is of securities not managed portfolios, but the linkages between these are strong. This JJM study is not unique – in 2001, John Woods and Mike Smith published a short paper "Investment Consultants' Fund Manager Recommendations: Is There Any Value in Them”. This is far from an overwhelming body of evidence, but it appears that investment consultants are loath to provide data on their recommendations, and much more.
These findings do not appear to have surprised or shocked many. A survey by Professional Pensions, in response to the question: “A study of US investment consultants has concluded that their manager recommendations add no value. Do you think this is true in the UK?”, - reported that 47% thought it true and 26% did not know. This is by no means a scientific survey, but more than 60% of its population report themselves as being trustees or in closely related positions.
However, one finding from this latest study offers scope for further analysis. It appears that pension schemes do rather slavishly follow the recommendations of their investment consultants, which means that we may be able to infer the quality of that advice from the performance of pension funds. Given the relative performance of pension funds’ overall investments, this does not appear to offer high hope of redemption. The JJM paper examines the determinants of manager selection and finds that “consultants’ recommendations are driven partly by the past performance of fund managers, but more so by non-performance factors, ...”. The analysis of the use of soft and service factors in manager selection by investment consultants is both interesting and a source of concern. Soft factors include such aspects as clear decision-making, capable portfolio manager, and consistent investment philosophy, while service factors include capabilities of relationship professionals, usefulness of reports prepared by the fund manager, and effective presentations to consultants. Quite how this latter point is relevant to investment performance is something of a mystery, though its value to consultants is clear. The cynic might well view the use of soft factors by investment consultants as little more than the introduction of a little “magic” into a process which otherwise might be reduced to algorithmic analysis of performance data.
Indeed, consultants do examine fund managers at considerable length and depth; far beyond simple investment performance metrics. Disclosure of changes of staff, losses of investment mandates and much more are routinely required. This raises some obvious questions. Where are the disclosures of changes of staff, the loss of advisory roles and similar soft factors from investment consultants?
Many have attributed the use of investment consultants to the relations of trust that develop between trustees and investment consultants. This is positively dangerous for trustees – trust that is not merited and honoured can be expected to result in rent-seeking behaviour by the trusted. The idea that the use of an investment consultant provides a shield for trustees seeking to alleviate their fiduciary responsibilities with respect to members is also suspect. Trustees may well use investment consultants for other purposes – the hand-holding of Lakonishok et al.(Lakonishok, Shleifer & Vishny, 1992) – but that does not explain why they follow the investment recommendations offered by consultants.
In common with credit-rating agencies, investment consultants have developed a role as gate-keeper – controlling the access of fund managers to pension funds. The problems that this created and its centrality is the recent crisis are well known in the case of ratings agencies. The investment consultancy variant has many negative overtones, from the suppression of innovation (few new fund managers make it into recommended lists) to a lack of heterogeneity among the pension system’s investment portfolios. This lack of heterogeneity may even become systemically important, as many schemes invested in a particular fund may seek to exit at the same time on the downgrading of a consultant’s recommendation. One minor embodiment of this gatekeeper role is the presence of investment consultants in the trustee meetings evaluating and selecting managers.
The JJM study notes that the funds selected by investment consultants are biased towards the large, and the tendency of large funds to underperform is well known. This might once have been described as “buying IBM” to avoid criticism, but IBM’s travails in the past few decades have rendered that a less than convincing strategy. The report’s findings in this regard merit reproduction:
“we find no evidence that consultants’ recommendations add value to plan sponsors. On an equal-weighted basis, the performance of recommended funds is significantly worse than that of non-recommended funds, while on a value-weighted basis the performance is mixed, and the recommended and non-recommended products do not perform significantly differently from each other. The under-performance of recommended products on an equal-weighted basis can be explained by the tendency of consultants to recommend large products which perform worse. When we adjust for the different sizes of recommended and non-recommended products, we find that recommended products still fail consistently to outperform non-recommended products. The same result holds when we adjust for possible backfill bias.”
The Report ends with: “Among the consultants whose aggregate recommendations we have analyzed, some presumably do better than others, and a knowledge of differential performance would inform a plan sponsor’s decision about which consultant to appoint. Without this knowledge, plan sponsors are making appointments partly blind. An obvious policy response by regulators, or a market response by plan sponsors, is to require full disclosure of consultants’ past recommendations so that such decisions are better informed and, as a consequence, their assets more efficiently allocated.”
There is an overarching criticism here. In the absence of such disclosures by consultants, competition between consultants is suppressed. In fact, it is clearly in the interest of those consultants who do add value to disclose and demonstrate their value-added. To be credible, of course, such evaluations of value-added need to be independent of the consultant concerned.
The asset management industry has been subjected to many criticisms of their costs, fees and performance in recent years, with politicians promising to intervene with regulation. The investment consultancy industry can expect a similar treatment. It is in the interest of investment consultants to pre-empt that by full and fair disclosure. In the absence of this, it is clearly incumbent on trustees to reconsider their position. The required statement of investment principles is clearly incomplete without reference to the basis of advisor selection – and the views of the Pensions Regulator on that may be interesting, in the Chinese sense.
There remain a number of questions; such as can anyone can systematically and sustainably add value and if they can, why are they functioning as advisor rather than principal? It seems that investment consultants do function in a manner comparable to doctors; but the open question is the medical technology being applied – is this that of blood-letting and leeches, or of more modern scientific practice, of both prevention and cure.