Many find fault with paper critical of consultants

Investment consultants and asset owners disagree with an award-winning paper that questions the value consultants offer their clients.

The paper — “Picking Winners? Investment Consultants' Recommendations of Fund Managers” — asserts that consultants' recommendations of money manager strategies are not driven by investment performance, and instead are based largely on “soft factors,” such as “clear decision-making, capable portfolio management and consistent investment philosophy.”

The authors were unable to find evidence that recommendations based on those factors added any particular performance-based value, suggesting the search for winners is “fruitless.”

“They (consultants) may be adding value through the other decisions they help plan sponsors with, they just fail to do it in this particular decision: which asset manager to hire for a particular mandate,” in this case, active U.S. equities, said Jose Martinez, assistant professor of finance, University of Connecticut School of Business and co-author of the paper, which won the annual $10,000 Commonfund Prize this year.

But investment consultants and asset owners interviewed for this story cry foul.

Michael A. Rosen, a principal and chief investment officer at investment consultant Angeles Investment Advisors LLC, Santa Monica, Calif., said the questions clients should be asking are: “Over time, has the fund performed better than its benchmark? Has it done so with less risk? Has the manager achieved their objectives?”

“If so, then the consultants provide considerable value,” Mr. Rosen said.

He also said consultant recommendations being driven largely by soft factors rather than performance, is by design and is “a good thing.”

“Past performance is a poor indication of future results because performance can be affected by many complex factors, some of which are random or difficult to control or anticipate,” he said after reading the paper.

When asked to comment on the paper, Michael G. Trotsky, executive director and CIO of the $61 billion Massachusetts Pension Reserves Investment Management board, Boston, echoed the sentiment that consultants shouldn't choose investment strategies based on past performance.

“Past alpha generation has absolutely zero predictive ability for future performance,” said Mr. Trotsky.

Mr. Rosen explained that, while factors that affect past performance aren't consistent, a manager's strategy, discipline and process are.

“By evaluating these so-called "soft factors,' there's a much deeper understanding of what drives portfolio returns and of what environments are more conducive to outperformance,” he added.

In addition to not having any special powers to pick winners, the paper also notes that consultants lack transparency and tend to favor larger managers, which the authors say tend to perform worse.

Mr. Rosen said that the criticism that consultants tend to favor larger funds across the board didn't ring true to him, but said that the size of allocations often guide manager recommendations.

“If you're investing $300 million in a niche strategy, you're not likely to hire a manager that only has $200 million or $500 million under management,” he said. “There are advantages and disadvantages of scale, and one disadvantage is capacity constraints.”

In terms of the paper's criticism that consultants lack transparency, Tim Barron, CIO at consultant Segal Rogerscasey in Darien, Conn., said his firm was “very transparent” in its methods, but added he was glad that the paper raised the transparency question.

“Every asset owner should be re-examining if their governance program is providing success,” he added. “The value of this is to cast a light on whether or not the process is working.”

On an equally weighted strategy basis, the authors found that the average returns of recommended strategies were actually around 1% lower than those of other similar strategies. The paper doesn't take consultant fees into account.

“It's not consistent with how clients are viewing investment consultants,” said Mr. Barron. “Many asset owners have outsourced (manager selection) to consultants. If consultants were that bad at picking managers, they'd get fired.”

The paper also suggests that the hiring of investment consultants is a form of “hand-holding.”

“Following consultants' advice may act as a scapegoat, or a back-covering strategy, if things go wrong,” said Mr. Martinez. “They can fall back on, "we follow the advice of the experts,'” which fulfills their fiduciary duties.

However, executives of the asset owners that P&I spoke with found that assertion inaccurate.

“It's not necessarily hand-holding; it's a package you get from the consultant,” said Jonathan Shear, CIO and associate vice president for investment and treasury at University of Utah, Salt Lake City.

The university in April hired Fund Evaluation Group as investment consultant for the school's nearly $1 billion endowment, replacing LCG Associates. Mr. Shear said the endowment has about quadrupled in a dozen years, and its needs have changed. Thus, officials sought a consultant with the resources to help a larger endowment diversify its asset allocation.

“It's a combination of things. (As an asset owner,) you've got to look at what they bring to the table. It's asset allocation; it's research. It all has to fit together,” he added.

“For us, consultants provide a qualitative check for our own work,” said Mr. Trotsky.

He explained that while MassPRIM's consultant, Callan Associates Inc., is identifying managers, so is the PRIM staff. At the end of the process, they compare notes until a consensus can be reached.

“It's more collaborative than advisory. We do our own thinking and they do provide a valuable resource, but they're not driving the process,” Mr. Trotsky added.

When asked what value consultants bring to the table, Steve Edmundson, investment officer for Nevada Public Employees' Retirement System, Carson City, said “research capabilities and experience with large public fund structures are the primary things we're looking for. That includes everything from asset allocation to assistance with manager due diligence.”

In late February, the $34 billion Nevada PERS hired Wilshire Associates Inc. as a project consultant to perform a “second option” review of the fund's investment program. Callan is the current consultant.

“We're required to hire a non-affiliated consultant every 10 years to conduct a 10,000-foot overview of our investment program,” Mr. Edmundson said.

John S. Griswold, executive director of the Commonfund Institute, a research and educational arm of institutional investment manager Commonfund, said giving the paper the Commonfund Prize was meant to begin a conversation.

“It's not supposed to be any kind of indictment on the industry,” said Mr. Griswold. “But it's important for the industry to look at the governance side.”

Tim Jenkinson, professor of finance and head of the finance faculty at Said Business School, University of Oxford, and director of the Oxford Private Equity Institute, and Howard Jones, a Said senior research fellow, co-wrote the paper . n