The investing industry is littered with broken business models, but there’s none more thoroughly smashed to pieces than investment consultancy.
Research consistently shows that consultants extract value from the investment process; a US study in 2008, for example, found that the money managers who are fired by fund trustees on the advice of consultants subsequently outperform the managers who are hired.
Now Warren Buffett has put the boot in. At last weekend’s annual meeting of Berkshire Hathaway shareholders he explained in no uncertain terms how consultants generally make the recommendations they do out of self-interest; how they typically refer trustees to other consultants who in turn charge high fees; and how they continually tweak the advice they give so they can keep on charging year after year.
“No consultant in the world,” said Buffett, “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.”
Commenting on Buffett’s remarks, blogger Ben Carlson said this:
“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.”
I share Ben’s scepticism about the value that investment consultants add. That said, I do still think that consultants have an important part to play. And, it seems, so does Ben, because he then goes on to list a number of ways in which investment consultants can (and indeed some do) add value “beyond the standard money manager musical chairs”:
- client education and improved communication efforts
- behavioural 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 organisational planning needs and keeping investor emotions in check
- ensuring the portfolio’s asset allocation matches the risk profile and time horizon of the organisation
- documenting the investment process to ensure continuity 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
It’s a big responsibility being a fund trustee. It’s inevitable that most will choose to seek the help of outside consultants, and rightly so. But they need to decide exactly what it is they’re paying them to do — and only work with consultants who genuinely do add value.
Investment consultants of the future will be a very different animal to most of those in business today.