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The Emperor Wears No Clothes, Part 2: The Investment Consulting Business

How can a sophisticated industry, filled with incredibly bright people, that affects virtually everyone in the country, embrace basic principles that make little or no common sense?  I have been asking these basic questions during my four years in the investment industry (after 25 years in the business world, including almost 20 years as a partner in a major accounting firm), and I get more and more frustrated by what I hear.  You need to know.

This month, I’ll explore the underpinnings of what purportedly is the most objective and client-focused part of the investment industry – investment consulting.


We need to agree on terminology.  For my purposes, an investment consultant is a person who does not make actual investment decisions (such as which stocks to buy).  A consultant typically helps you to determine a strategic asset allocation (what percentage of assets to put in stocks, bonds and other asset classes, based upon your objectives and risk tolerance); identifies and performs due diligence on desirable managers in each asset class; oversees your selected managers; and reports their performance back to you.

An investment manager is a person who picks stocks (or other investments), although his firm may well employ consultants who provide advice just as an investment consultant does.

Let’s eliminate from consideration the consultants in the slimier part of the profession – the ones who receive sales commissions, kickbacks, etc., from the investment managers and products to which they steer their customers.  Instead, I will focus on the better elements of the investment consulting industry.

Style Boxes

Last month, I revealed some of the craziness behind style boxes.  Yet, most consultants advocate style boxes.  Why?  Since a consultant doesn’t pick stocks, he needs some other mechanism to ensure diversification within an asset class.  So the consultant selects managers and insists that they select stocks only within their respective boxes so that they can’t overlap in their stock selections.  Since each stock can appear in only one style box, different style managers by definition can only pick different stocks.

Consequently, few consultants will select a manager who professes to be “all cap” or “not style specific.”  The manager might generate outstanding results, but he doesn’t fit the consultant’s style box mode.  You don’t get that manager; rather, you get style box managers.  The fact that the boxes are arbitrary and that it is unlikely that a manager can be an expert in all of the industries within his box apparently is irrelevant.  Indeed, if a manager dislikes the stocks in his box and drifts into another style box to select better stocks, the consultants will fire him, irrespective of his performance.

Amazingly, a consultant’s customer still might not be well diversified.  The reason is that companies in the same industry can appear in multiple style boxes.  Despite the style boxes, you could be insufficiently diversified by industry, which seems more significant to me.  Unfortunately, that is beyond most consultants’ ability to control, so it’s rarely addressed.

A Basic Inconsistency

Consultants’ most appealing selling point is that they say they can find the best managers.  Indeed, manager selection is their primary deliverable.  Every consultant brags about his proprietary database, uses a proprietary screening process and visits each manager every year to kick the tires.

Yet, statisticians have proven that it is very difficult, if not impossible, to select managers who can consistently beat their indexes.  Frankly, I believe the statisticians.  In the face of this evidence, a very few consultants have begun recommending index funds, rather than managers, for the bulk of a client’s stock market money.  But they have to be careful.  If a consultant goes too far with that advice, you may not need him any more.


Many consultants proudly negotiate discounts from managers.  That reduces your cost and might even offset the consultant’s fee.  But is that wise?  Is it really in your best interests?  Think like a manager for a minute.  If you have a really great product (i.e., great investment performance) and investors are showering money on you to get it, would you discount your fees?

The fact is that there are managers who are interested in marketing, meaning amassing assets under management to increase their own income.  And there are managers who are interested in generating results for their clients and would prefer fewer clients paying full fare than masses paying coach fare.

Is your consultant trying to make his fee more palatable by getting discounts for you, or is he really trying to get you the best after-all-costs investment returns?  If you ask, he’ll say that discounting is not a criterion in his manager screening process.  I’ll give him the benefit of the doubt.  But, it begs the question of whether the manager’s willingness to discount is evidence of an underlying issue.  Indeed, in my firm, willingness to discount fees is a strike against a manager.

Limited Accountability

OK, suppose you believe that your consultant has the prowess to beat the odds and find the best managers.  How do you know whether your consultant is successfully earning her keep?  Ask a consultant to demonstrate the value she provides to her clients.  Wouldn’t it be nice to know about her clients’ actual historical investment returns?  The response?  “We don’t have that kind of data.  Every client is different, so one client’s results are not representative of what another’s results might be.”

Baloney!  Truth be told, the consultant has identified two or three managers in each asset class and style and recommends the same managers to every client, perhaps in different proportions based upon asset allocation.  The fact is that if a manager underperforms, the blame is placed on the manager.  The consultant fires the manager and recommends a new one.  It’s never the consultant’s fault.  There simply is no way to determine whether she is worth her fee.

Nature of the Business

Investment consulting is a low-margin, highly competitive business.  The only way to make money in consulting is to have a very large amount of assets under advisement (meaning lots of clients) and provide a very standardized service to their owners.

This segment of the investment industry has a great deal of difficulty competing for talent with the much-higher-margin money managers, hedge funds and product sales firms.  I mean no disrespect.  There are some very bright, well-intentioned folks with high integrity in the consulting business.  But you need to understand that the low fee that you pay has implications as to both the value and the level of service you get.

If your head is starting to spin, it should.  The investment consulting industry has been drinking its own Kool-Aid for a long time, and you, the customer, lap it up because it sounds good.  Yet, perhaps it is possible that the emperor wears no clothes even though some of the most upstanding people in the village proclaim that he does.

Assuming the industry does not successfully execute a contract on my head, I’ll be back with more next month.

Ross Nager is Senior Managing
Director of Sentinel Trust Company of
Houston, Texas.




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