(MoneyWatch) Many retirement plans, foundations, universities, endowments and other plan sponsors hire investment consultants. It's estimated that as of June 2011, over $13 trillion of tax-exempt U.S. institutional assets were advised on by investment consultants. Previous studies have found that over 80 percent of U.S. public plan sponsors and half of corporate sponsors engage consultants.
While a consultant can add value in many ways, including asset/liability modeling, strategic asset allocation, benchmark selection, and performance monitoring, a key question is -- do they add value? The authors of the study "Picking Winners? Investment Consultants' Recommendations of Fund Managers," sought the answer to that question. They examined 13 years of data (1999-2011) from Greenwich Associates on the aggregate recommendations of consultants with a share of over 90 percent of the U.S. consulting market. The study was limited to the recommendations on domestic, long-only stock funds. The following is a summary of their findings:
- While past performance plays an important role in consultants' recommendations, they are also heavily influenced by soft factors (such as clear decision making, capable portfolio manager, consistent investment philosophy, quality of reports, and quality of service).
- Confirming that manager selection is a highly valued service, recommendations have a very significant effect on fund flows.
- Despite the value placed on the advice, there was no evidence that manager recommendations add value to plan sponsors. On a value-weighted basis there was no evidence that recommended products significantly outperform other products. However, on an equally-weighted basis, average returns of recommended products are actually around 1 percent lower than those of other products. This result is confirmed using one-, three- and four-factor pricing models, and the differences in every case are statistically significant.
- There was a significant negative impact of fund scale on performance, fully explaining the underperformance of recommended products.
The last point is important because it demonstrates that even in the presence of skill, successful active management sows the seeds of its own destruction -- success leads to net inflows. The authors concluded, "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." This finding raises the interesting question: Why do plan sponsors continue to hire consultants?
One explanation might be that they value the other services consultants may provide. However, that doesn't explain why they continue to follow their fund recommendations. The most likely reason would seem to be that they are unaware that the recommendations have no value. Another possible explanation is "CYB," or cover your behind -- providing someone other than themselves to blame if things go wrong. While self-preservation can be a powerful motivator, it's not helping the plan members, nor the plan sponsor itself.
Image courtesy of Flickr user Tax Credits