Are Investment Consultants Useless?

Andrew Ross Sorkin, editor at large of the New York Times' Dealbook reports, Doubts Raised on Value of Investment Consultants to Pensions:
Here’s a brainteaser: Would you invest $10,000 in a mutual fund without knowing its past performance? Probably not. Yet, if you were in charge of $13 trillion of pension money, would you accept the recommendation of an investment consultant without knowing its performance record? The answer is yes. It happens every day.

Welcome to the bizarre world of pension funds and investment consultants. At a time when individual investors are increasingly demanding transparency in performance track records, the biggest slice of the investment world — pension funds — has conspicuously turned a blind eye to demanding track records from their most influential advisers, investment consultants.

A new study by professors at the University of Oxford is causing a stir in the staid pension investment industry, highlighting the subpar performance of most consultants and, more important, the lack of disclosure that would allow the public to even know about it.

The study demonstrates, perhaps for the first time, that the investment consultants that pension funds rely on to advise them about what funds and investments they should make — resulting in tens of millions of dollars in fees each year — are, as one of the authors of the survey says, “worthless.”

“It’s a waste of money listening to consultants,” Howard Jones, one of the authors of the study, told me he concluded. “It’s a service that is useless.”

Mr. Jones and his colleagues, Tim Jenkinson and Jose Vicente Martinez, examined the recommendations of investment consultants from 1999 to 2011 related to United States equities. It culled the data from Greenwich Associates, which had collected it anonymously from 29 firms, representing 91 percent of the entire investment consulting industry’s market share in the United States.

The result of the study is nothing short of breathtaking if you’re in the investment management business: “The analysis finds no evidence that the recommendations of the investment consultant for these U.S. equity products enabled investors to outperform their benchmarks or generate alpha,” a measure of performance that adjusts for risk. The study found that, on average, the consultants’ recommendations underperformed their benchmarks by about 1 percent.

Those recommendations are worth big fees to the consulting firms. In 2012, Calpers, the big California pension fund, paid $33 million in fees to outside investment consultants. CalSTRS, the California teachers’ fund, spent nearly $9 million. New York State and Local Retirement System spent nearly $7 million. Pennsylvania State Employees’ Retirement System spent about $4 million. The list goes on.

The investment consulting industry has always been a powerful force in directing how trillions of dollars are allocated every year to different investment firms and hedge funds, but it has long hidden in the shadows. Pension funds hire the outside consultants to help them determine where to invest their money. “Consultants’ recommendations have a large influence on investor allocation decisions and confirms survey data which reports that manager selection is one of the most highly valued services offered by consultants,” the study found.

According to a survey conducted in 2011 by Pensions and Investments, 94 percent of pension funds use a consultant. Of those, nearly a quarter of the pension funds said the recommendation by a consultant was “crucial” to their decision and 40 percent said it was “very important.”

Yet the firms don’t disclose their track records. About six firms control about 60 percent of the market, Mr. Jones said. The biggest and most influential investment consultants are Mercer Investment Consulting, Russell Investments, Towers Watson Investment, Cambridge Associates, Hewitt EnnisKnupp, R. V. Kuhns & Associates, Callan Associates, Pension Consulting Alliance, Strategic Investment Solutions and Wilshire Associates. Wilshire has long been a top consultant to Calpers, for example.

Why do pension funds use outside investment consultants?

“It’s backside-covering,” Mr. Jones said. “It’s easy to say you took expert advice,” saying the rationale is similar to the adage “Nobody got fired for hiring I.B.M.”

That may be a bit unfair. There is clearly a place for consultants, who can often introduce pension funds to new asset classes or particular investment managers, a point Mr. Jones made as well. But as investors, consultants are, well, no better than consultants.

Mr. Jones’s study said that one reason pension funds don’t hold the consultants accountable for their advice was that they were considered “‘money doctors with whom investors develop a relationship of trust, and this in turn gives them confidence when they select fund managers.”

Still, the lack of transparency on performance track records seems to be a conspicuous hole in the investment process.

Somewhat oddly, Andrew Kirton, global chief investment officer at Mercer, was quoted this week in the trade magazine Pensions and Investments defending the lack of transparency.

“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 said. “You can make yourself potentially a hostage to data.”

Mr. Jones said he was perplexed when he read that. “They are not willing to be transparent with their own performance,” he said. “It has to make you very curious about their motivations.”

Ultimately, Mr. Jones wrote, the lesson of his research “would be to require investment consultants to provide the same high level of disclosure as that which is provided by fund managers on their performance, or the same level of disclosure provided by research analysts on their stock recommendations.”
One of the comments to this article came from Richard Holbrook, who writes:
I had very extensive experience with consultants over a 30-year period when I managed hundreds of millions of dollars for dozens of pension fund sponsors.
I totally agree with Howard Jones. Not only are the consulting fees a huge waste of money, the investment results have generally been poor for the last ten years.
Consultants have aggressively pushed more sponsors into the hiring of layers of hedge fund and private equity managers; such investments have returns significantly below those of the S&P 500.
The consulting industry is replete with conflicts of interest:many managers are required to purchase expensive analytical and measurement services from consultants just to be eligible for consideration as a potential sponsor hire.
One of the mentioned consulting firms is known for conducting manager searches and invariably coming to the recommendation that its own investment firm is the best choice.
As well, many private equity firms have continued to carry investments at book cost when the true market value is much lower.
The reality is that consultants and high-fee managers have been bleeding sponsors for years; it is only now starting to become evident.
I don't agree with everything in the comment above but Mr. Holbrook raises excellent points. I recently discussed the looting of pension funds and wrote that everyone wants a piece of the U.S. public pension pie, especially consultants. They yield tremendous power and have effectively become the "gatekeepers" for most pension funds looking to make investments to external managers.

They are also the prime beneficiaries of a poor governance system which has allowed them to essentially hijack the entire investment process, recommending their clients invest with the large well-known hedge funds and private equity funds, ignoring smaller funds that typically outperform. Keep in mind what I wrote when looking at the struggles of small hedge funds :
... the consultants act as gatekeepers and their business model is flawed.  It's a volume business where they prefer shoving all their clients in the same brand name funds because it's easy to pass these investments through the board and they get to keep their relationships with the larger hedge funds intact. If you're a consultant, are you going to waste your time performing due diligence on smaller funds? Of course not, it's costly and much easier to build and maintain your relationships with the big brand name funds, especially if you are investing in them in a separate fund (huge conflict of interest!).
Keith Porter discusses his thoughts on this topic in his latest blog comment, Biting the hand that feeds, going over similar problems in Canada and making specific recommendations to help smaller managers obtain a level playing field:
I would recommend everyone involved, but especially the beneficiaries and trustees of schemes, to start asking what their managers and consultants are doing to recommend smaller firms. Given that these funds have better performance, don’t trustees have a fiduciary duty to be asking the question?

I would recommend regulators introduce more asymmetric regulation, with sensibly easier rules for smaller funds. When I managed long - short for High Net Worth clients, I was doing it on a managed account basis, so I had no access of any sort to the client funds, and all the trades I executed were reported directly to the clients, who were all accredited investors. Yet I had to put up the same regulatory capital as if I were a hedge fund, which ended up killing the project.

Many US States have rules to invest minimum amounts with minority owned firms. How difficult would it be to extend that to firms below say $250M AUM?

For large State funds, the press should be asking why so much is outsourced to external managers. Some administrations have a problem paying “Wall St” wages, but are happy to pay millions in fees to Wall St. There are a lot of good managers and analysts who would be very happy making a good salary at a State fund. Ontario Teachers’ Pension Plan would be a fantastic role model for them.

Consultants need to be more proactive. They need get involved at a much earlier stage and to set up platforms that are easy for anyone to promote themselves, even a dart-throwing monkey. Instead of complaining that smaller funds need to do a better job marketing themselves, they should be helping them market themselves – the whole point is that you want the smaller funds to be managing money.

I am probably wildly optimistic, but I believe that if small firms can get this kind of support, it can rapidly become a self-sustaining “ecosystem”, as successful funds grow, and unsuccessful ones die, their seed capital gets returned to the pool to seed the next generation.
Keith is talking up his book but he too raises excellent points. Unfortunately, he's wildly optimistic as things won't change in Pensionland. A few consulting firms are dominating the market and their business model is working just fine for them. And to be fair, their clients are happy too because their chief concern is managing career risk, not necessarily what is in the best interest of their plan's beneficiaries.

I'm being quite harsh and cynical but it's high time this issue gets discussed openly and receives proper media coverage. In my opinion, it all boils down to governance, or lack of proper governance. If plans don't compensate public pension fund managers properly and consultants have to sign off on their investment decisions to appease some politically nominated board (not an independent investment board), then we shouldn't be surprised with their poor investment results. Their governance model is weak and ensures mediocre performance because there is a lack of accountability.

Are investment consultants useless? Of course not. There are good and bad investment consultants with all sorts of experience, fancy degrees and industry accreditations. But there is no denyng that for far too long, investment consultants have escaped scrutiny and that needs to be changed.

There is a reason why six firms dominate the industry. True, the well-known consulting shops can afford to pay top talent and they typically look for people with actuarial degrees, CFAs and FRMs. But it's also true the requests for proposals (RFPs) pension funds put out are skewed to favor these big firms, virtually ensuring their growth no matter how badly they underperform smaller firms which offer independent advice with no conflicts of interest. In other words, just like with well-known hedge fund "gurus," you're not always getting what you're paying for but the packaging is a lot better and career risks a lot lower.

Pension funds relying on investment consultants should disclose fees and performance and there should be an independent evaluation of these consultants every year. Most U.S. pension funds do disclose the fees but they rarely disclose the performance or discuss reasons of why a mandate has been renewed or terminated.

Moreover, I highly recommend pension funds increase their use of smaller consulting firms that offer independent advice and even hire individuals with actual pension fund experience on some mandates. If I told you that I can gather a few people here in Montreal who can produce top-notch research and results for your pension fund or sovereign wealth fund at a fraction of the cost, you'd probably laugh, but that is the truth. And unlike others, the people I know have managed money and allocated to external managers. Moreover, they don't have any conflicts of interests and couldn't care less about what some big hedge fund or private equity manager thinks of them. They will show you who is delivering alpha, not beta, and discuss the prospects of each fund going forward, not looking backward.

Actually, let me flat out ask pension funds and investment consultants, including the "big six" investment consultants, to contact me directly ( to discuss my idea of setting up an independent advisory firm here in Montreal. I love blogging on pensions but want to get back into investment research helping clients with specific mandates across public and private investments. I see so many advisors peddling such terrible advice and know I and some former colleagues can do a much better job by offering truly independent advice based on years of actual pension fund and investment experience.

And let me end by plugging two smaller consultants I know who have pension fund experience and are working hard on behalf of their clients. One is Bruce Friesen of Global Investment Solutions. Bruce boasts one of the best databases on managers and he offers great insights and advice. The other is Ioannis Segounis of Phocion Investments. Ioannis is a performance specialist who can help your fund with all sorts of performance issues, both internally and with external managers. If you think your performance system and reporting are up to snuff, think again, he'll find something wrong and recommend changes to improve them.

Below, Cliff Asness, co-founder of AQR Capital Management, and Lawrence Schloss, chief investment officer for New York City, talk about the challenges of meeting pension obligations. They speak with Bloomberg's Erik Schatzker at the Bloomberg Link Markets 50 Summit in New York. Great discussion, well worth listening to.