Do The Kingmakers Have Clothes?
Research Roundtable Publication
“Investment consultants are the kingmakers of institutional asset management.”
“By assigning recommendations to fund managers, or withdrawing those recommendations, they have the power to influence which managers are hired and fired.”
These were the opening sentences of a new paper from researchers at the University of Oxford and the University of Connecticut about the power and accuracy of the investment claims and recommendations made by leading investment consultants.
In the past, we asked this question in a summary of previous research by three of the same academics, Jenkinson, Jones and Martinez: Are The Selectors Good at Selecting?
Back in 2013, they answered our question with this quote:
“We find no evidence that [investment consultant] recommendations add value.”
Based on this, why do so many dollars continue to be influenced by large investment consultants?
As we mentioned in our last piece on this subject, Trillions of Influence, unfortunately, researchers from University of Lausanne, Arizona State University, and Purdue University found that these manager selectors seem to be “influencing trillions the wrong way.”
In their latest paper, Virtual Reality?, Cookson, Jenkinson, Jones and Martinez, add to the inquiry by looking at how investment consultants present the performance of the mangers they recommend.
Instead of inserting our views into the research, the words and phrases in the body of this post are largely in the form of direct quotes from the independent research paper, which we have noted in italics.
Do investment manager selection kingmakers have any clothes?
We will let you draw your own conclusions.
In keeping with what we recently wrote in a piece with Joachim Klement titled, How to Actively Add Value, investors should keep an eye out for outlier investment opportunities – some exist, as do quality investment consultants.
As an alternative to the industry continuing to promote the notion that value primarily equals one’s ability to consistently find top performing investment managers, consider this quote from one of our previous posts:
“Would we add more value, strengthen relationships, and increase trust in our industry if we were more open, transparent, and candid about our ability to find outliers at the correct time?”
We continue to think so.
Overview of Investment Consultants Claims
Investment consultants market their services by claiming their fund manager recommendations add significant value.
Consultants exaggerate their own performance in largely nontransparent ways.
While disclosures by mutual funds, institutional products, and stock analysts are standardized, performance reporting by investment consultants is neither regulated nor standardized.
Consultants’ performance disclosures are voluntary and essentially unverifiable.
In making claims about the performance of their past recommendations, investment consultants typically reveal only the output of their own analysis, but little about their methodology, and nothing of the raw recommendations themselves.
Exaggerated Outperformance and Risk Adjusted Claims
Large differences exist between consultants’ claims on the one hand and analysis of their performance on the other.
[Consultant’s] claimed outperformance ranges from 1.64% per year to 2.49% per year, yet their actual performance according to our calculations is significantly lower and varies between -0.92% per year and 0.29% per year.
No consistent differences [were found] between recommended and non-recommended products in terms of return volatility or betas with respect to manager-chosen benchmarks.
This suggests that there are no significant differences in terms of risk [in managers recommended by consultants.]
Reasons Driving Discrepancies
Analysis suggests not only that consultants’ claimed performance is wide off the mark, but also that their disclosures are difficult to compare, making them poor guides even to their relative performance.
Four practices [were identified], which together explain most of the discrepancy:
- Comparison of recommended products [gross of fees] to benchmarks rather than to other products available in the same investment category
- Inclusion of simulated and backfilled returns in the performance analysis
- Use of restrictions leading to survivorship bias
- Arbitrary exclusions of products and investment categories in calculations
It is common practice for consultants to compare the [gross or pre-fee] returns of their recommended products against the returns from a benchmark index. It is, however, a questionable practice.
Others, like the exclusion of certain products and investment categories… are opaque to asset owners.
Another source of the discrepancy… is the inclusion of simulated and backfilled returns.
Databases used by consultants are usually incomplete and… are more likely to report past returns [only] if those returns are good. As a result, products that perform poorly are likely to be under-represented in the backfilled sample.
One of the consultants [studied also takes]… into account only the excess performance of managers that were given a top rating for fixed periods of time, typically five years or longer.
Therefore, [if the consultant] downgraded a manager after, say, four years and nine months of receiving a top rating, that manager would not appear in the five-year assessment.
This practice, which involves a look-ahead condition, is problematic in light of the tendency of consultants to base their recommendations partly on the past performance of products. The approach, which we refer to as the opportunity to forget losers, increases [the consultant’s] performance by 0.27% per year.
[All] together… the performance of [the consultants] is boosted by 1.16% per year.
Performance Disclosures
Another statistic sometimes reported by consultants is the percentage of their recommended products that outperform benchmark indices over different horizons.
These statistics present several problems.
First, as we have seen, comparing product returns [gross of fees] against benchmarks… is misleading.
Even more problematic, however, is the survivorship bias which is mechanically introduced by such a comparison.
Other problems identified in previous sections, such as arbitrary sample selection and inclusion of backfilled and simulated returns, are also likely to affect the results.
Researcher’s Conclusions
Investment consultants tend to overstate their ability to select fund managers.
Investors face an almost impossible task in assessing not just the absolute but also the relative performance of investment consultants.
The task of investors is made even more difficult by the fact that consultants do not set out their methodologies clearly… and that they tend to result in biases that clients may not be able to understand.
This opacity and upward bias in consultants’ claims, may help to explain the considerable impact that consultants’ recommendations have on investment flows.
Related Reading:
Virtual Reality? Investment Consultants’ Claims About Their Own Performance – Jenkinson, Jones, and Martinez – 2021
Top 5 Ways OCIO Fees Mislead – Commonfund – 2021
Choosing Investment Managers – Goyal, Wahal, and Yavuz – 2020
Trust and Delegated Investing: A Money Doctor Experient – Germann, Loss, and Weber – 2018
Fund of Funds Selection of Mutual Funds – Edwin J. Elton, Martin J. Gruber, Andre de Souza – 2017
Picking Winners? Investment Consultants’ Recommendations of Fund Managers – Jenkinson, Jones, and Martinez – 2014
The Selection and Termination of Investment Management Firms by Plan Sponsors – Goyal and Wahal – 2008
The Road Less Traveled – Simple Alternatives 
Are Most Investment Managers One Hit Wonders? 
The Certain Drag on Performance – Taxes