Academic Paper Questions Investment Consultant Value

A recent academic research paper argues that using institutional investment consultants to make fund and portfolio manager choices is “fruitless” when it comes to driving outperformance.

Tim Jenkinson, of the University of Oxford Saïd Business School; Howard Jones, also of the University of Oxford Saïd Business School; and Jose Vicente Martinez, of the University of Connecticut, are authors of the paper, which reviews the longstanding practice among institutional investors (including corporate retirement plans) of hiring investment consultants or advisers to drive asset manager decisions.

The research team focuses on U.S. actively managed equity investments, but suggests the findings may apply more widely across asset classes and investment approaches. They also favored U.S. active equity because it is “not only the largest asset class, but provides us with the largest and longest data set.”

The researchers cite an earlier paper from 2008, which estimated that 82% of U.S. public plan sponsors use investment consultants, as do 50% of corporate sponsors. Overall, the paper finds that investment consultants’ recommendations for these plan sponsors “are driven largely by soft factors, rather than the funds’ past performance, and that their recommendations have a very significant effect on fund flows. However, we find no evidence that these recommendations add value.”

Interestingly, the researchers find that consultants’ recommendations only correlate weakly with the past performance of a fund manager, while other nonperformance factors correlate much more strongly with consultant recommendations. This suggests that consultants’ recommendations do not merely represent a return-chasing strategy, the researchers note.

“We also find that, other things being equal, larger products attract more recommendations,” the paper finds. “Next we compare consultants’ recommendations of funds with fund flows. We find very significant flows of funds into, and out of, products following changes in recommendations by investment consultants; for instance, attracting (or losing) recommendations from one-third of the investment consultants results, on average, in an increase (or decrease) of around 10%, or $0.8 billion in the size of the investment product within one year.”

The paper also strives to assess the performance of the funds recommended by investment consultants, finding little to suggest investment consultants are guaranteed to improve performance for institutional investors.

“We measure performance both gross and net of fund managers’ fees,” the paper explains. “Starting with returns relative to benchmark, on a value-weighted basis we find no evidence that recommended products significantly outperform other products. However, on an equally-weighted basis, we find that average returns of recommended products are actually around 1% lower than those of other products.”

The researchers suggest this result is confirmed using one-factor, three-factor, and four-factor pricing models, “and the differences using returns against benchmark and factor models are in every case statistically significant.”

“We also measure the performance of products in the one- and two-year period after they have experienced a net increase or decrease in the number of recommendations they receive; we do so in order to test for the possibility that consultants’ recommendations add value in the short term, but then become stale and fail to make a contribution,” the paper explains. “However, there is no evidence that the net increase or decrease in the number of recommendations predicts superior or inferior performance respectively.”

The full paper can be downloaded here