Many elements of investment practice were born out of what we call “academic research.” For instance, such widely used concepts as modern portfolio theory and the Sharpe ratio.the research puzzle | Many of the ideas get extended beyond where their authors intended them to go. The Sharpe ratio is a case in point. “Active share” is a more contemporary case study, having gone from a little-discussed conceptthe research puzzle | This is the essay I wrote about it in 2010. to a hotly debated one.InvestmentNews | Here is an article about that change.
Among practitioners and journalists, more and more attention is being paid to the flow of working papers coming from professors. A good recent example is “Picking Winners? Investment Consultants’ Recommendations of Fund Managers,” by Tim Jenkinson, Howard Jones, and Jose Vicente Martinez.SSRN | At the time of this writing, the paper is identified as slated to be published in the Journal of Finance. As evidence that it struck a nerve, articles about it appeared in two publications aimed at institutional asset owners within days of each other.
The Pensions & Investments piecePensions & Investments | This appeared in the April 20, 2015 print edition, but is only available to P&I Daily subscribers online. ran with the headline, “Many find fault with paper critical of consultants.” Chief Investment OfficerChief Investment Officer | A newer publication, CIO has become an important industry voice. posed a broader question: “How Do You Solve a Problem Like Consulting?” The paper and the articles are important reading for those who use investment consultants. (Disclosure: While most of my consulting work is focused on organizational improvement, I do serve in a traditional investment consulting role for a client.)
One of the conclusions of the paper — that there is “no evidence that consultants’ recommendations add value to plan sponsors” when picking asset managers — fits with the evidence found elsewhere. Manager selection is very difficult and consultants struggle to do it well (just like everyone else). Interestingly, the authors found that recommendations from consultants are driven “partly” by past performance, but more so by non-performance factors. That’s a surprising conclusion, since consultants very rarely recommend managers that have underperformed.
The research is narrow in scope, so it’s a mistake to take any of the conclusions too far. In awarding the paper the Commonfund Prize, the head of Commonfund Institute indicated that the action “was meant to begin a conversation” about the underlying issues.
Among them should be: What are consultants expected to do for clients? Is it really all about “picking winners”? For example, consultants that were interviewed by the publications discussed the critically important responsibility of providing asset allocation recommendations, which was not addressed in the paper. What is the value of doing that well in comparison to selecting managers?
If nothing else, the dialog about the paper ought to point out the need for a greater understanding of how consultants do what they do. Are they good at “hand-holding,” and is that of value? Do their recommendations serve mainly as cover for asset owners, existing to provide evidence of the exercise of fiduciary duty? Does the need for a narrative for decision makers to pass along to institutional stakeholders turn much of the consulting process into a story-telling one rather than an analytical one?
Looking at it another way, if the classic “four Ps” (philosophy, people, process, and performance) that many consultants apply to managers were instead turned on themselves, would investors be able to adequately judge them? Probably not, since there hasn’t been as much transparency and scrutiny as there should be.
For example, how do consultants perform due diligence? What percentage of the time do they pick past winners when recommending managers? How prone are they to select larger managers (who, according to the paper, tend to underperform)?
Lacking awareness of the answers to those and many other questions, it is hard to judge the value of consultants. Yet most asset owners don’t pursue those answers. In addition, as the Chief Investment Officer article points out, there are serious potential conflicts of interest for consultants.
Some stem from the rising popularity of the outsourced CIO (OCIO) capabilities that many consulting firms are offering (and which are much more financially attractive to them). Others are long standing, like the conference and research businesses that generate revenue from the very managers that they are expected to be objective about. And there are many subtle pressures as well. As one consultant said, “You develop a list of favorite managers — you can’t help yourself.” Favored managers are hard to fire, and emerging cracks in their approach are hard to see for what they might become when you are conditioned to celebrate their strengths.
Are there investment consultants that add value? If asset owners hope to pick the winners among them, they need to evaluate them in a much more expansive way. If an academic paper on a limited topic can help to get people talking about the big issues that haven’t been explored sufficiently, then it has made a positive contribution, quite apart from how it will be judged for its conclusions.