To borrow a joke from the movie “Shrek,” money management is like a parfait — it has a lot of layers. There’s the person who recommends investments for you — a financial advisor, a wealth manager, a pension-fund manager or a private banker. Then there are the managers of the funds they invest in, or which you invest in on their recommendation. Finally, there are brokers, dealers, exchanges and other intermediaries that handle the actual trading of the assets the fund managers buy. Each layer takes a cut from your wealth — sometimes in the form of a commission or flat fee, but sometimes in the form of a percent of your savings.
There are even more layers buried deep within the asset-management parfait. One such layer is investment consultants. Firms such as Aon Hewitt, Mercer and Cambridge Associates provide investment services to retirement-plan managers who, together, manage tens of trillions of dollars of wealth. The consultants help the money managers pick assets and mutual funds, model the risk and reward of these investments, track performance and so on.
Academics haven’t studied investment consultants very closely in the past, but a recent paper tries to shed some light on this little-known corner of the financial world. In “Picking Winners? Investment Consultants’ Recommendations of Fund Managers,” economists Tim Jenkins, Howard Jones and Jose Vicente Martinez examined the performance of the funds that investment consultants recommend to their clients from 1999 through 2011.
Their findings should give the financial industry pause. Investment consultants are certainly effective in getting managers to invest in the funds they recommend — a fund that can persuade one-third of the big consultants to start recommending it to their clients can expect to get an additional $800 million of assets a year. With an expense ratio of 1%, that would net the fund’s managers $8 million in annual income.
But Jenkins et al. find that investment consultants aren’t promoting funds that perform well. On average, their choices tended to return about 1.12 percentage points less than the ones they didn’t recommend. Part of that difference reflects the consultants’ fees, but even before fees are subtracted, the recommended funds do significantly worse than others. This is true even after taking standard measures of risk into account, suggesting that the underperformance doesn’t come from consultants selecting safer investments.
Why are consultants steering their clients toward underperforming funds? Jenkins et al. find that past performance does make a fund more likely to be recommended, even though all evidence indicates that it’s difficult for funds to sustain good performance over time. But, judging from surveys of consultants, other factors are even more important in determining which funds they pick — for example, how consistent they think the fund managers’ investment philosophy is, or how good they think their presentations are. In other words, lots of consultants are using a seat-of-the-pants method to choose which funds to recommend, and it isn’t working very well.