Papers question worth of consultants

Institutional investors would be just as successful by randomly picking U.S. equity managers than by taking the recommendations of investment consultants, new research from Oxford University's Saïd Business School shows.

Two complementary research papers released Aug. 27 and Sept. 17 by the Oxford, England-based school argue that, although pension funds and other institutional investors rely heavily on consultants when picking U.S. equity managers, the consultants add no value.

Andrew Kirton, Mercer's London-based global head of investment consulting, conceded the institutional investment consulting world is not as transparent as the retail world. Still, he believes the school's research is “a bit sensationalistic” and “uninformed,” as it only draws conclusions from examining U.S. equities, “the hardest asset class (in which) to find alpha” and add value.

Howard Jones, a senior research fellow at the Saïd Business School and co-author of the reports, noted in an interview that consultants are not merely “return-chasing” when they form their recommendations, basing them on a wide array of criteria. “We think if there was more transparency of their past recommendations, then a greater separation would be possible between those with better and worse track records,” Mr. Jones said.

“We're just trying to shine a bit of light on a small, but important, part of the market.”

Based on the analysis of 29 investment consulting firms — accounting for more than 90% of the market — U.S. equity managers recommended by consultants underperformed others not recommended by consultants by 1.1% per year between 1999 and 2011 on an equal-weighted basis.

Jose Martinez, a lecturer in finance and a co-author of the papers, said the researchers got data from Greenwich Associates, Stamford, Conn., on what money manager strategies consultants recommend. They then gathered performance data on those managers' strategies from eVestment LLC, Marietta, Ga., and compared it to performance data from eVestment on strategies not recommended by consultants.

“Consultant recommendations don't seem to have any significant predictive power as to which funds are going to do better than others,” Mr. Jones said.

Investment consultants had more than $13 trillion of U.S. institutional assets under advisement as of June 30, 2011, according to the school's research, with 82% of public defined benefit and defined contribution plan sponsors and half of corporate DB and DC sponsors using consultants. On a global basis, consultants advised on $25 trillion of assets.

A lack of transparency appears to be the biggest problem. Consultants ruthlessly scrutinize money managers but pension funds can't impose the same level of scrutiny on consultants because consultants don't provide information on their past recommendations, Mr. Jones said.

The papers recommend institutional investors require consultants to make their past recommendations public in the same way that money managers disclose investment performance or the way that research analysts disclose their recommendations.

“Investment consultants do not disclose their past recommendations publicly in a way that would allow their accuracy to be measured. Some consultants show their "value added' by comparing the performance of a portfolio of their recommended funds with that of an appropriate benchmark. However, they do not generally compare this performance with the performance of institutional funds which they do not recommend, nor do they make available the underlying data for scrutiny by third parties,” one report states.

“Consultants have been loath to give up their prior recommendations,” Mr. Jones said in the interview. “Plan sponsors don't have that information.”

The research found that investment consultants' recommendations have a significant effect on institutional asset allocation, with plan officials' asset allocation decisions following consultants' recommendations.

A Pensions & Investments' 2011 survey of more than 300 institutional investors, which the school's research cites, found 94% employed an investment consultant.

Of the respondents that used a consultant, 23% rated consultants as “crucial” to the operation and success of their plans, while 40% rated them as “very important.”

In addition, the Oxford business school's research finds no evidence that consultants' recommendations add value.

On an equal-weighted basis, the performance of recommended managers is significantly worse than that of non-recommended managers, while on a value-weighted basis, the performance is mixed and the recommended and non-recommended strategies do not perform significantly differently.

“The underperformance of recommended products on an equal-weighted basis can be explained by the tendency of consultants to recommend large products, which perform worse,” one paper states.

When adjusted for the different sizes of recommended and non-recommended strategies, recommended ones still fail consistently to outperform non-recommended strategies.

The same result holds when adjusted for possible backfill bias.

There are three reasons institutional investors often rely on consultant recommendations, according to Mr. Jones:

• They gain confidence to take more risks;


• They often want to back up their decisions with the opinion of a consultant; and


• They simply don't know how accurate the consultant's recommendation are.

Unsurprisingly, consultants take issue with the papers' conclusions.

Mercer's Mr. Kirton argued the research ignores the idea that in the institutional investor sector, retail-level transparency can tempt consultants to prematurely change their recommendations with managers, instead of maintaining a long-term view in an attempt to appear more “on top of” the market.

“It's in our clients' interest to have the level of transparency that we have. We're not forced by marketing purposes to give advice we think isn't the best due to polishing numbers that makes us look better in a survey,” Mr. Kirton added. “You can make yourself potentially a hostage to data.”

“The devil's in the details,” said John Meier, managing director at San Francisco-based Strategic Investment Solutions, in an interview.

“There's no standard way to measure performance for a consultant. Valuating the process is a whole lot harder than it sounds,” Mr. Meier said. n