Death By a Thousand Cuts

In the U.S., over $13 trillion of institutional capital relies on consultants for advice on which funds to invest in. Pensions, endowments, foundations and other large pools of money utilize consultants for a range of services, most notably picking different outside money managers to invest in on their behalf.

Research shows that investment consultants as a group add no value through their selection of investment managers. They chase past performance and make far too many unnecessary changes. Data also shows that the managers consultants fired have gone on to perform better than the ones they hire.

The paradox here is that these non-profit institutions need outside advice in most cases. The majority don’t have the time or resources to monitor their portfolios or pick and choose new investments. That’s a full-time job and many of these funds can’t hire full-time investment staff. The problem is they’re paying for the wrong kind of advice.

Warren Buffett seems to agree with me. Here are his thoughts from the Berkshire Hathaway annual meeting last weekend:

Supposedly sophisticated people, generally richer people, hire consultants, and no consultant in the world is going to tell you ‘just buy an S&P index fund and sit for the next 50 years.’ You don’t get to be a consultant that way. And you certainly don’t get an annual fee that way. So the consultant has every motivation in the world to tell you, ‘this year I think we should concentrate more on international stocks,’ or ‘this manager is particularly good on the short side,’ and so they come in and they talk for hours, and you pay them a large fee, and they always suggest something other than just sitting on your rear end and participating in the American business without cost. And then those consultants, after they get their fees, they in turn recommend to you other people who charge fees, which… cumulatively eat up capital like crazy.

And the consultants always change their recommendations a little bit from year to year. They can’t change them 100% because then it would look like they didn’t know what they were doing the year before. So they tweak them from year to year and they come in and they have lots of charts and PowerPoint presentations and they recommend people who are in turn going to charge a lot of money and they say, ‘well you can only get the best talent by paying 2-and-20,’ or something of the sort, and the flow of money from the ‘hyperactive’ to what I call the ‘helpers’ is dramatic.

Like clockwork, every year at non-profit board meetings around the country consultants pitch a few new fund ideas to replace the current cellar dwellers in the portfolio. A steady stream of new ideas makes it seem like consultants are adding value and doing their job while getting rid of the underperformers gives everyone someone to blame.

No one wants to admit there’s a problem with this model of doing business so status quo reigns. It’s hard enough to pick one money manager that can outperform, but when you try to pick multiple outperformers and do that multiple times every year your odds just continue to get smaller and smaller. The degree of difficulty is through the roof on this approach.

Here are three consequences of the control the consulting industry has over the institutional investment landscape:

1. As a group, hedge fund performance has been abysmal over the past decade or so. Consultants and those picking the consultants don’t receive nearly enough blame for this. The hedge funds are, in most cases, just giving these large institutional investors what they ask for (usually a strategy to fight the last war). Consulting firms pitch their “access” to top performing funds, but that’s usually the funds that outperformed in the past, not to be duplicated in the future.

2. Very few institutions know how to evaluate the consultants who are picking money managers on their behalf, let alone how to vet the money managers themselves. So non-profits basically put their faith into these consultants and hope for the best without an understanding of their actual results (benchmarking in the institutional world is often a joke with very low hurdles).

3. These portfolios end up hurting performance through a death by a thousand cuts. They change a few managers each year. Then they change consultants every few years. Or they change investment committee members. There’s no continuity in their investment approach and each time these changes are implemented there are explicit and implicit costs incurred.

Here are a few areas where consultants could add value if they chose to focus their efforts beyond the standard money manager musical chairs:

  • Client education and improved communication efforts.
  • Behavioral management and modification.
  • Useful performance and risk reporting that doesn’t include 100 page reports with useless information no one reads.
  • Setting realistic expectations, which can help with both organizational planning needs and keeping investor emotions in check.
  • Ensuring the portfolio’s asset allocation matches the risk profile and time horizon of the organization.
  • Documenting the investment process to ensure continuity in the program over time.
  • Saying ‘no’ over and over again to investments or funds that don’t fit an institution’s mandate, tolerance for risk or stated objectives.
  • Ensuring that short-term liquidity needs are always able to be met by implementing cash management guidelines.
  • Honesty, transparency and the ability to say “we don’t know.”
  • Reminding these organizations of their time horizons and long-term goals.
  • Doing nothing most of the time in terms of making changes to the portfolio.


Learn more about our institutional business here.

Further Reading:
Doing Nothing is a Decision


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