New Tips And Triks For You

Small-time thinking, that's what holds me back.

A few weeks ago, I advised ultra-affluent families how to improve the performance of their $200 million portfolios. I see now that my sights were set too low. The ones who really need my advice are our country's pension plans and nonprofits. Offhand, I think I can save them about $91,650,000,000 a year.

The problem came to my attention when I read an important new study by Tim Jenkinson, Howard Jones and Jose Vincente Martinez of the Said Business School at Oxford: Picking winners? Investment consultants' recommendations of fund managers.

Here is the situation:

Imagine that you are on the investment committee of a major pension plan, charity or university. You need to allocate a significant portion of your portfolio to U.S. Equities. Problem: there are up to 1,000 institutional-class mutual funds from which to choose. What do you do?

Since plan sponsors are charged by the Employee Retirement Income Security Act of 1974 (ERISA) or the Uniform Prudent Investor Act (UPIA) to exercise fiduciary responsibility over the $13+ trillion in investment assets they oversee in this space, you might think that the people sitting on these investment committees must be wizards of finance. Evidently not. Ninety-one percent of the public pensions and fifty percent of the private plans feel the need to hire outside consultants for hand-holding to help them pick U.S. stock mutual funds.

What do these consultants bring to the table? This is the pith and marrow of the new research.

Jenkinson, Jones and Martinez found that for the 13 years from 1999 to 2011, the funds that consultants recommended underperformed the ones they failed to recommend by about 1% annually. In other words, the consultants' advice subtracted 1% in utility every year.

How do the consultants come to these remarkable picks? You're probably thinking that, given the high level of sociopath that works on Wall Street, it involved visits to strip clubs and under-the-table kickbacks. No, that's way off. Their due diligence required counting the number of stars each fund got from Morningstar.com:

...both qualitative and quantitative assessments. Qualitative assessment looks at aspects of a manager's investment process and business ... [blah blah blah] ... funds are categorized into broad groups, based on their future expected performance relative to appropriate benchmarks. (p.9)

The work product is a "story" the consultants can tell the investment committee about the recommend fund manager in order to make them feel good about their selection. Jenkinson et al emphasize that consultants do not just pick recent winners. This is probably a mistake, since if they did the funds at least would have momentum on their side.

Why do these funds hire consultants who demonstrably destroy value?

Agency theory suggests that this gives the plan sponsors someone to blame. They can always fire consultants and hire new ones. This is a lot better than firing themselves. Imagine no possessions. According to a 2008 study by Goyal and Wahal, this merry-go-round leads nowhere, as the new investment managers they hire end up performing no better than the old managers they fire.

In the case of university endowments and charities, this underperformance is probably of little consequence. These groups waste money on such a scandalous scale that they would do just as well shoveling half of it into the furnace, which would at least have the benefit of heating the building.

The pension plans are a horse of a different kettle of fish. They hold the future retirement of American workers hostage. These plans have been mismanaged and stand woefully underfunded, such that they now require about an 8% return going forward to meet their obligations. No one thinks this is believable or achievable. They are in a pickle.

The ace up their sleeve is that they can always put the liability to the U.S. taxpayer via the expediency of the Pension Benefit Guaranty Association. Workers will not be happy with the ensuing retirement pay cut, but that's not really the plan's problem at that point, now, is it? Because this conveniently puts a floor on the pension plan's liability, it gives them license to roll the dice with the portfolio and hope that the consultants and active managers bail them out and restore solvency. So what if they've missed their investment targets by over 2% a year for the past decade? There's always next year.