Consulting & The Smart Money Herd Mentality

Institutional investors are often referred to as the ‘smart money’ or ‘sophisticated investors.’ For some funds this is true, but many of these large pools of capital make the same exact mistakes as mom and pop retail investors. It’s just that the reasons are different.

Here are a few studies to consider:

• One study looked at large pension plans, with an average size of $10 billion each. Nearly 600 funds were studied from 1990 to 2011. Researchers found these funds allowed their stock allocation to drift higher during the late-1990s tech bubble. Then they allowed their equity exposure to stay lower at the tail end of the 2007-2009 financial crisis. So they were overweight going into a crash and underweight going into a recovery. Instead of rebalancing they simply chased past performance, thus missing out on the inevitable mean reversion and failed to manage risk according to their stated guidelines.
• Researchers also looked at the performance of the nation’s largest pension plans from 1987 to 1999. Out of the 243 plans in the study, each investing hundreds of millions or even billions of dollars, 90% of them failed to beat a simple 60/40 benchmark.
• Researchers looked at a dataset of more than 80,000 annual observations of institutional accounts from 1984 through 2007. These funds collectively managed trillions of dollars in assets. The study looked at the buy and sell decisions among stocks, bonds, and externally hired investment managers. The researchers found that the investments that were sold far outperformed the investments that were purchased. Instead of systematically buying low and selling high, these funds bought high and sold low.
• Researchers looked at the investment choices from consulting firms that control roughly 90% of the U.S. consulting market. They found, “no evidence that consultants’ recommendations add value to plan sponsors.” In fact, the average returns were much worse in the funds they recommended than non-recommended funds.

The last one interests me the most because I began my career in the institutional investment consulting business. We were a smaller, private shop, but our competition was the bigger players. And these big players basically control the entire market. In the U.K., the six largest consultants control 70% of the market. In the U.S. the top ten consultants have an 81% share. Worldwide, the top ten controls 82% of the market.

I understand why pensions, endowments and foundations use consultants. Not everyone has the expertise or resources to manager money in house or make these decisions on their own.

But if these consultants are considered experts in their field of choosing money managers, why are the results so poor?

A few thoughts:

• Consultants constantly feel the need to give as much advice as possible. They have to try to prove that they’re worth their fees, so they advise changes even when none are needed. This has a lot to do with the fact that these funds are now so worried about their short-term performance measured against the market and their peers.
• People love to have someone to blame. The funds can blame the consultants. The consultants can blame the money managers. And the money managers can blame the Fed. Everyone is happy except for the end investors, the beneficiaries.
• This business model is predicated on scale, which is why the market is so concentrated. But this means that there has to be a herd mentality as everyone is investing in the same managers and strategies. It also means there is little room for personalized advice when you’re overseeing trillions of dollars in assets as some of these firms do. So there is something of a cookie-cutter approach to these models.
• It’s very difficult for these firms to offer objective advice. Consultants typically have a list of approved money managers that they use. It’s not very easy for managers to make it onto these lists, but it is very lucrative once they do because that means they will likely be recommended across many different client accounts. The consultant-manager partnership can be tricky for trustees to understand from a conflict of interest perspective.
• These firms assume that their number one job is to beat the market, provide sources of alpha and help their clients pick the best fund managers. Manager due diligence tends to overshadow things like asset allocation, performance monitoring, risk management and educating the trustees or board members on things like portfolio construction, setting return expectations, reminding them of their overall goals and how the markets and human nature generally work. The search for alpha often blinds investors from paying attention to the basics.

The last bullet point is probably the most critical for these large pools of capital to understand. They waste so much of their time debating the relative merits of the different money managers and short-term investment opportunities that they lose sight of their overall goals and organizational mission. Selecting the best investment opportunities doesn’t matter if your can’t control your behavior or implement within an overarching plan.

Consulting firms can be helpful to institutional investors. They just have to learn to focus on the right areas of importance.

Further Reading:
Goals-Based Investing