The majority of institutional investors rely on consultants to make recommendations on everything from asset allocation to manager selection. Three professors at Said Business School at Oxford University have shown in a recent paper that consultants do not add any value when they select US equity managers on behalf of their clients. This study was newsworthy enough to grab Andrew Ross Sorkin’s attention in The New York Times “Deal Book”.
The weakness of the investment consultants is an open secret in the institutional money management business. Neither clients nor money managers are about to blow the whistle, so it has been left up to Professors Jenkinson, Jones, and Martinez to debunk one aspect of the consultant’s role: manager selection. The reason clients don’t denigrate consultants is because clients have adopted the consultants’ recommendations, and because consultants are useful foils to deflect criticism and pressure from trustees and staff. Money managers dare not speak the truth about consultants because the consultants are gatekeepers for many pension plans and endowments. Attack consultants, and a money manager will find that he can’t get on their recommended list, even if his performance is acceptable.
Thus, there is an unholy alliance that virtually guarantees that performance will not exceed benchmarks. Pension plans hire consultants to give them cover, consultants recommend money managers, and money managers underperform. Eventually the consultant recommends firing the very manager he suggested and proposes hiring another one. After a while the board of trustees will fire the consultant because performance hasn’t measured up to the benchmark, and a new consultant will be retained. The new consultant will recommend firing a bunch of money managers and hiring new ones. You don’t need an academic study to tell you that this system of finding, retaining, and firing money managers isn’t going to add value.
As the authors of the Oxford study and Mr. Sorkin lament, the major consultants do not provide their individual historic track records for clients to examine. In other words, institutional investors hire consultants without having a clear picture of their historical efficacy or futility.
I need to add a brief word about those pesky benchmarks. All too often if a consultant’s recommended managers aren’t beating their benchmarks, the consultant will offer up a benchmark study. The study has two big benefits. The consultant gets to earn additional fees. In addition, the underperforming managers are given a grace period while the study is conducted and until the manager has been given a sufficient opportunity to underperform the new benchmark.
When I managed the pension plan for the State of North Carolina, I was extremely fortunate. There wasn’t a consultant in sight. We saved a bunch of time and money. The State Treasurer figured that we’d get blamed for our mistakes whether or not there was a consultant involved in our investment process. We didn’t need the Oxford study to assess the value of investment consultants.