Are Consultants Hampering Active Management?

Self-Imprisoned? How's this for a headline? Alpha Wounds: Benchmark Tail Wags the Portfolio Management Dog. If that makes a lick of sense to you, then you read far too much about investments. (But thanks.)

The article itself, however, is lucid.

Jason Voss, a former portfolio manager who now works for the CFA Institute (the research affiliate of the organization that runs the Chartered Financial Analyst program), writes that active investment managers could perform better but are hampered by institutional barriers. Voss is not the first to make that argument, but he states the case particularly well. He also is fair in pointing out that if he is correct, that investment managers have nobody to blame but themselves: "The wounds are self-inflicted."

Voss posits that investment-management companies follow a predictable life cycle: fast out of the gate, receding over time. This performance erosion occurs because the company loses focus. At the beginning, the only way for a new investment-management firm to attract clients is through investment gains. Once those early returns have been scored, though, the firm begins to think, "With these returns in hand, we can now gather assets by telling the world our good news story." Its attention then turns toward sales, away from investment-management activity.

Worse, these sales conversations end up affecting the investment-management function. As the company visits with what Voss calls "investment adjuncts"--private wealth managers, registered representatives, consultants, and others who assist in the distribution process--it is asked a barrage of questions. (For clarity's sake, I will use the more common term of "consultants," rather than "adjuncts.") This exercise is innocently intended, as consultants have every right to try to understand why they might favor this particular investment manager "from among the vast sea of such beasts."

Unfortunately, the effect is smothering, as the questions are accompanied by measurements that bind. Voss writes, "Now if a manager wants to raise assets under management through marketing, the price is to clear the preferred mathematical hurdles of the adjuncts. Particularly pernicious, and especially germane to the current discussion, are the concepts of 'style box', 'style drift', and 'tracking error.'"

Voss' tale is clear. An investment-management firm initially pursues its craft as best it can, free from the burden of expectations. As the company accrues clients, however, and spreads the word among the investment community, it is prodded and poked by well-meaning observers into becoming something different. The animal is tamed. It moves in the investment-consultant zoo, and behaves accordingly.

Examining the Claim Is the tale correct? Well, it is consistent with the facts. Emerging investment-management companies often do post outsized performance. It is also true that as they receive assets, they expand their marketing (and client-service) departments, and that the larger and more mature they become, the more conservative they tend to get. For a tiny investment-management firm, mistakes of omission are worse than mistakes of commission: They need to do something. For a giant firm, the reverse holds true: Better to trudge along than to surprise a client.

However, there is another way of explaining the investment-management life cycle that has nothing to do with the pressures applied by consultants: regression to the mean. Many aspire to manage money--it's a wonderfully profitable business, even today with the pressure from index funds. These aspirants start businesses. Some of these emerging investment managers post excellent early returns and attract the attention of consultants. They begin to appear on investment databases. Others do not and fade into nonexistence. By this explanation, the early returners never were all that. They were merely fortunate in that the initial coin landed heads. Future coins behave more normally, and the fund's performance subsides.

If regression to the mean is the driver, then the damage caused by consultants is mostly imaginary. The issue is instead one of mathematical inevitability, which is a common thing indeed. Almost a century ago, the first of the "great businesses" papers was written, identifying corporations that were unusually profitable. Various explanations for these companies' results were given. A decade later, those corporations were no longer extraordinary. This pattern would be repeated time and time again in business literature, most famously with Tom Peters' 1982 best-seller In Search of Excellence. The profiled firms did not remain excellent.

The data cannot directly indicate which of the two factors is largest, the consultants or regression to the mean. Unless they start a registered mutual fund, failed investment startups go largely unrecorded. Consequently, the manager database is not sufficiently complete to permit a proper study. What we do know, at least with hedge funds, is that investment managers who are not required to disclose (that is, those who run money in other ways besides registered funds) game the system. They pop up and report results when the numbers are good. They disappear when the numbers are not.

We can, of course, examine the performance of relatively unconstrained mutual funds to see whether those funds beat their more-staid competitors. Here is how United States diversified stock funds look when sorted by tracking error. I grouped all actively managed U.S. large-company stock funds according to their five-year tracking errors: highest third, middle third, and lowest thirds. Ditto for U.S. small-company funds. (In each case, I used only the oldest share class for a fund, rather than the entire alphabet.) The table shows the groups' five-year total returns and standard deviations.

There is a small something there--if one ignores risk. With large-company funds, the high-tracking-error funds did indeed outpace other funds, by 50-80 basis points per year. However, they gave that advantage back by assuming extra risk. The news was less favorable with small companies, where the medium-tracking-error group matched the high-tracking-error group's returns, but with lower risk. With small companies, the medium-tracking-error group was the clear sweet spot.

Morningstar ministudies have not found an advantage for other flavors of high-conviction managers, including those who run concentrated funds, those who run unconstrained bond funds, those who have high active share scores, and those who run go-anywhere "all-cap" funds. Thus, the empirical evidence supporting Voss' argument, at least as demonstrated by mutual fund results, is pretty sketchy.

Summary Obvious, Voss' article will strike a chord with active investment managers. If they only had the chance to exercise their expertise, free of constraints, think how they could soar! (Admit it, you sometimes feel that way about your boss.) But as discussed in last week's column, experts perpetually overrate their abilities. In most fields, with most subjects, they cannot achieve what they believe they can. Investment management is likely no exception. To the extent that active management struggles to compete against index funds, consultants would seem to be only a minor factor.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.