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.
Gatekeepers
In common with credit-rating agencies, investment consultants have developed a role as gatekeepers, controlling the access of fund managers to pension funds. The problems that this created and its centrality in 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. 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 underperformance 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.”
Full disclosure
The report ends with: “Among the consultants whose aggregate recommendations we have analysed, 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 adviser selection – and the views of The Pensions Regulator on that may be interesting, in the Chinese sense.
There remains a number of questions to be answered; such as can anyone systematically and sustainably add value, and if they can, why are they functioning as adviser rather than principal?It seems that investment consultants do function in a manner comparable to doctors; but the open question concerns the medical technology being applied – is it that of blood-letting and leeches, or one of more modern scientific practice, of both prevention and cure?
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