There is overwhelming empirical evidence that investment managers struggle to beat their benchmarks.
A large consultant and advisor business exists, however, with the premise that unique skill exists that allows experienced investors to select “best of breed” strategies and outliers that can consistently rank highly among peer groups and outperform indexes.
The big question is:
Are the “selectors” really skilled at identifying the outperforming managers and does their “selecting” add value?
A 2015 study, Picking Winners? Investment Consultants’ Recommendation of Fund Managers, published in the Journal of Finance, attempted to answer this question.
Unfortunately, for many of us who have worked in the field for many years, the answer is brutal:
After analyzing the recommendations of investment consultants, who at the time represented 90% of the institutional U.S. manager selection market, researchers found no statistically significant evidence that funds recommended by the consultants outperformed funds not recommended by the same consultants.
In conclusion, they stated this:
“The search for winners, encouraged and guided by investment consultants, is fruitless.”
Another blow to both the open architecture manager selection business has now been published by the Critical Review of Finance titled Fund of Funds Selection of Mutual Funds.
In the study, the authors scrutinized the universe of “fund of funds managers.”
Often, these managers select investment strategies within their fund families, which is a potential conflict of interest.
As the paper mentions, though, this also gives these “selectors” 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, researchers found this:
Fund of funds managers select funds that significantly underperform a random selection of mutual funds.
Based on all of this, the next 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.
Trillions of Influence – Elisabetta Basilico and Preston McSwain – 2019
Trust and Delegated Investing: A Money Doctor Experient – Maximilian Germann, Benjamin Loss, Martin Weber – 2018
Fund of Funds Selection of Mutual Funds – Edwin J. Elton, Martin J. Gruber, Andre de Souza – 2017
Say It Ain’t So, Joe – Preston McSwain – 2017
Picking Winners? Investment Consultants’ Recommendation of Fund Managers – Tim Jenkinson, Howard Jones, Jose Vicente Martinez – 2013
On Persistence in Mutual Fund Performance – Mark M. Carhart – Journal of Finance – 2012
Money Doctors – Nicola Gennaioli, Andrei Shleifer, Robert W. Vishny – Chicago Booth Research Paper – 2012
Luck Versus Skill in the Cross-Section of Mutual Fund Returns – Eugene F. Fama, Kenneth R. French – Journal of Finance – 2010
Challenge to Judgment – Paul A. Samuelson – Journal of Portfolio Management – Fall 1997