To borrow a joke from the movie "Shrek," money management is like a parfait -- it has a lot of layers. There's the person who recommends investments for you -- a financial adviser, a wealth manager, a pension-fund manager or a private banker. Then there are the managers of the funds they invest in, or which you invest in on their recommendation. Finally, there are brokers, dealers, exchanges and other intermediaries that handle the actual trading of the assets the fund managers buy. Each layer takes a cut from your wealth -- sometimes in the form of a commission or flat fee, but sometimes in the form of a percent of your savings.
There are even more layers buried deep within the asset-management parfait. One such layer is investment consultants. Firms such as Aon Hewitt, Mercer and Cambridge Associates provide investment services to retirement-plan managers who, together, manage tens of trillions of dollars of wealth. The consultants help the money managers pick assets and mutual funds, model the risk and reward of these investments, track performance and so on.
Academics haven't studied investment consultants very closely in the past, but a recent paper tries to shed some light on this little-known corner of the financial world. In "Picking Winners? Investment Consultants' Recommendations of Fund Managers," economists Tim Jenkins, Howard Jones and Jose Vicente Martinez examined the performance of the funds that investment consultants recommend to their clients from 1999 through 2011.
Their findings should give the financial industry pause. Investment consultants are certainly effective in getting managers to invest in the funds they recommend -- a fund that can persuade one-third of the big consultants to start recommending it to their clients can expect to get an additional $800 million of assets a year. With an expense ratio of 1 percent, that would net the fund's managers $8 million in annual income.
But Jenkins et al. find that investment consultants aren't promoting funds that perform well. On average, their choices tended to return about 1.12 percentage points less than the ones they didn't recommend. Part of that difference reflects the consultants' fees, but even before fees are subtracted, the recommended funds do significantly worse than others. This is true even after taking standard measures of risk into account, suggesting that the underperformance doesn't come from consultants selecting safer investments.
Why are consultants steering their clients toward underperforming funds? Jenkins et al. find that past performance does make a fund more likely to be recommended, even though all evidence indicates that it's difficult for funds to sustain good performance over time. But, judging from surveys of consultants, other factors are even more important in determining which funds they pick -- for example, how consistent they think the fund managers' investment philosophy is, or how good they think their presentations are. In other words, lots of consultants are using a seat-of-the-pants method to choose which funds to recommend, and it isn't working very well.
Of course, there's always the possibility that corruption is involved in some parts of the industry. Financial regulators have investigated whether investment consultants took kickbacks in states such as New York and Rhode Island.
Possible conflicts of interest aside, the real problem is that investment consulting is just another layer in the asset-management parfait whose value added is dubious. To recap: If you're an average worker, much of your retirement saving is either in a corporate retirement plan or a government pension plan. You're paying the plan managers a fee. They're paying investment consultants a fee. The consultants are recommending funds that also charge a fee. Each of these fees directly or indirectly comes out of your savings.
But it's likely that few or none of these fee-charging layers results in better asset allocation. Financial markets aren't perfectly efficient, but they're close enough that it's very hard for most money managers to outperform the market. Yet they keep trying and trying, and the cost of their failures gets passed on to the American worker, who may not even notice the fees that are eating away at their life savings.
Why do so many layers of the financial system keep charging for subpar returns? In a report titled "The Folklore of Finance," researchers at asset manager
State Street Corp. theorized that most players in the financial system are still way too focused on trying to beat the market. Since that's a zero-sum game, most money managers, consultants and others should refocus their efforts on providing value in other ways -- helping investors to understand their own needs and preferences, and providing better information about the risks and rewards available in the market.
Abandoning the hope of beating the market is a good idea for most financial players -- but if implemented, it would probably reduce the flow of fees that feeds the whole system. Like an overly fancy parfait, asset management might be better with fewer layers.
Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University.
