The
recently published study in the Journal of Finance, “Picking Winners?Investment Consultants’ Recommendations of Fund Managers”, makes a carefully
researched assertion that consultant recommendations have little value.
Worthless may be too strong, but that is close to what most would conclude when
they read the paper. Given all of the work on trader skill and market
efficiency, this should not be surprising. But, given that consultants supply
their work do leading pensions, it is should be surprising that no one has
called them on their recommendations.
The
authors do a very careful job of researching this topic through analyzing what
drives recommendations. Recommendations are driven by more than past
performance but by soft factors such as philosophy, service, fees, and size.
Consultants are not return chasers but are slaves to size which is a key driver
for this results. The soft factors also seem to be key drivers for recommendations.
The due diligence process identifies managers that have a well-defined process
and can explain well. Given their client base and job, consultants have to be
size sensitive. Perhaps in an imperfect world, the best they can do is conduct
due diligence and make the best recommendations given size constraints.
Nevertheless,
it may be too easy to let them off the hook based on the size argument. First,
there is no evidence of outperformance and equal weighted portfolios of
recommendations underperform. Second, these performance results hold for a
number of different factor models. Third, the size or scale effect can explain
the underperformance, but it cannot explain why the recommendations do not
outperform alternatives.
Use your consultants carefully. If you want them to sift through
managers and find those that meet size criteria and have well-defined
processes, you are in safe ground. If you are asking them to pick future
winners, beware. The responsibility of picking winners can be delegated but
don't expect that they will be able to find a holy grail of outperformance. It
seems like sticking to basics is still best. Stay diversified with asset
classes and strategies. Don't try and select individual winners, but focus on
the right asset allocation and adapt your betas to the environment when
necessary.
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