The Performance of Consultants that Recommend Active Funds
There is overwhelming empirical evidence that active mutual funds struggle to beat their benchmarks.
The results have been consistent, from Challenge to Judgment, written in 1974 by Nobel Laureate Paul Samuelson, who demanded the following:
“Brute evidence to prove that fund managers could consistently beat the market.”
The economist Burton Malkiel then popularized the idea that returns from a simple long term buy-and-hold indexing strategy would exceed the returns of funds carefully curated by investment professionals. His book, A Random Walk Down Wall Street, which is now in its 12th edition, has sold over 1.5 million copies.
More recent studies like Persistence in Mutual Fund Performance, by Carhart in 1997, and Fama and French, Luck Versus Skill, from 2010, with brute research, also question the ability of managers to consistently outperform the market or index funds, which can now track indexes within 100ths of a percentage point.
A large consultant and advisor business exists, however, with the premise that unique skill exists that allows experienced investors to select “best of breed” managers and strategies that can consistently rank highly among peer groups and outperform indexes.
The big question is whether “selectors” are good at “selecting.”
Are they really skilled at identifying the outperforming managers and does this skill really add value in dollar terms to investors?
A 2015 study, Picking Winners? Investment Consultants’ Recommendation of Fund Managers, published in the prestigious Journal of Finance, attempted to settle this question once and for all.
Unfortunately, for many of us who have worked in the field for many years, the answer is brutal:
The authors analyze the global consultant community with a combined share of 90% of the worldwide consulting market on U.S. funds.
They found no statistically significant evidence that funds recommended by consultants outperform (provide alpha) funds not recommended by the same consultants.
In fact, they concluded with this:
“The search for winners, encouraged and guided by investment consultants, is fruitless.”
Another blow to both the open architecture manager selection business, and some egos, has now been published by the Critical Review of Finance titled Fund of Funds Selection of Mutual Funds.
In the study, the authors scrutinize the universe of “fund of funds managers.”
Often, these managers of managers select within their fund families, which is a potential conflict of interest. As the paper mentions, however, this also gives them a privileged position in terms of what is really going on inside portfolio management teams (insider information in a good way).
Despite the privileged position, the finding is that these fund of funds managers select funds that significantly underperform a random selection of mutual funds.
Based on all of this, the question might be:
Do these selectors influence investors?
According to Jenkinson et al. (2015), a fund that is recommended by the consultants in the sample receives a staggering $2.4 billion in additional inflows when compared to a fund that does not receive consultant recommendations.
Considering that the evidence seems to be clear that many, if not most, active fund recommendations don’t add value, why do investors continue to put so much emphasis on hiring manager picking consultants?
The answer might be found again in academic research.
In Money Doctors, a study published in the Journal of Finance in 2014, the authors present a model where financial advice is a service comparable to the practice of medicine.
As the authors wrote:
“In our view, financial advice is a service, similar to medicine. We believe, contrary to what is presumed in the standard finance model, that many investors have very little idea of how to invest, just as patients have a very limited idea of how to be treated.”
“Just as doctors guide patients toward treatment, and are trusted by patients even when providing routine advice identical to that of other doctors… money doctors… that help investors make risky investments and are trusted.”
In other words, investors place a great deal of faith in the recommendations of their money doctor advisors and consultants.
And, in a follow-on CEPR, Trust and Delegated Investing: A Money Doctors Experiment, researchers found that “investors are willing to take substantially more risk when a money manager is [viewed as being] more trustworthy.”
Related to this trust, unfortunately, Money Doctors also found that due to biases in their beliefs and profit margin conflicts, managers often “do not correct misperceptions.”
In our view, when a high level of trust exists, especially related to someone’s physical or fiscal well-being, professionals of any type have a high level of responsibility to be transparent.
Based on this, should consultants and advisors in the industry be more open as it relates to what the evidence says about our ability, or lack thereof, to consistently find managers that add value over simple index funds?
We think so.
Picking Winners? Investment Consultants’ Recommendation of Fund Managers – Tim Jenkinson, Howard Jones, Jose Vicente Martinez – September 2013
Fund of Funds Selection of Mutual Funds – Edwin J. Elton, Martin J. Gruber, Andre de Souza – March 2017
Money Doctors – Nicola Gennaioli, Andrei Shleifer, Robert W. Vishny – Chicago Booth Research Paper – August 2012
Trust and Delegated Investing: A Money Doctor Experient – Maximilian Germann, Benjamin Loss, Martin Weber – May 2018
Challenge to Judgment – Paul A. Samuelson – Journal of Portfolio Management – Fall 1997
On Persistence in Mutual Fund Performance – Mark M. Carhart – Journal of Finance – April 2012
Luck Versus Skill in the Cross-Section of Mutual Fund Returns – Eugene F. Fama, Kenneth R. French – Journal of Finance – October 2010