After World War II, U.S. institutional investment plan portfolios began to grow rapidly. In 2021, the overall assets of private and non-private pension plans within the United States alone exceeded $30 trillion. Much like their predecessors within the mid-Twentieth century, the trustees who oversee these assets have limited time and ranging levels of experience. This forces them to depend on the recommendation of employees and non-discretionary investment advisors.
My goal here is to focus on a very harmful bias of investment advisors. This revelation is vital since it is usually obscured by the incorrect claim that their advice is conflict-free.
The problem is that while investment advisors may claim that their advice is conflict-free – and their clients may consider them – the truth is that it is usually heavily influenced by the investment advisor’s own interests.
The origins of the conflict
The basic requirement for investment advisors to say no conflicts of interest is that their recommendations are unbiased because they don’t have any financial interest within the funds they recommend. Such a claim can have been valid in the course of the occupation’s childhood within the Seventies and Nineteen Eighties, when investment advisory firms limited their services to performance reporting. But by the Nineties, competition had change into so intense that the majority of those firms introduced their very own asset allocation and asset manager recommendations to distinguish themselves from the competition.
Emboldened by their status as trusted advisors, they began pushing actively managed funds in traditional asset classes, whilst signs mounted that such investments were unlikely so as to add value. Complicating matters, they sought to emulate the success of the Yale Endowment within the early twenty first century and encouraged the development of increasingly complex portfolios with allocations to non-public investments in alternative asset classes. Despite the change of their business models, consulting firms continued to offer performance reports, and their reports increasingly resembled an assessment of their very own recommendations.
Today, investment advisory firms still compete totally on the depth of their resources in asset allocation, lively manager selection, and alternative asset classes, amongst other aspects. Many claim their recommendations are trustworthy because their business models are “conflict-free.” The problem, nevertheless, is that this claim implicitly assumes that investing in complex portfolio allocations, lively managers and alternative asset classes will profit clients overall. What if the other is true? What if these strategies actually destroy value? Would investment advisors tell their clients?
Simply asking these questions presents an existential dilemma. If most clients are higher off simplifying their portfolios, replacing lively managers with low-cost index funds, and avoiding alternative asset classes, then the present investment advisory business model is obsolete.
This is understandably difficult to just accept, and investment advisory firms rarely discuss these issues for obvious reasons. The conflict of interest affects their judgment. For this reason, most firms proceed to compete based on their (largely unfounded) skills in asset allocation and manager selection.
Trustees also find it difficult to challenge advisors’ claims. Why? This is because investment advisors almost at all times select the benchmarks against which plan performance – and subsequently performance – is assessed. It is just not of their interest to set the bar too high. Actually, Niklas Augustin, Matteo Binfarè and Elyas Fermand found that non-public equity benchmarks have drifted toward lower and lower thresholds for outperformance. By any measure, it is a deeply contradictory practice, however the widely accepted claim that counselors are conflict-free makes it much more damaging.
How is that this conflict going? An example of that is that investment advisory firms recommend actively managed funds but take little responsibility for his or her results. This could also be hard to consider, but ask an investment advisory firm to offer an independent assessment of their recommendations for hiring and firing fund managers. Few firms volunteer this information because (a) they never thought to do the evaluation; (b) they don’t need to perform the evaluation due to findings contained therein; or (c) they conducted the evaluation but didn’t share it based on the findings therein.
None of those explanations encourage confidence. However, on account of their non-discretionary status, investment advisors are rarely questioned. Because the fiduciaries are the ultimate decision-makers, advisors aren’t chargeable for demonstrating whether their recommendations add value. Ironically, the “non-discretionary cloak of invisibility” protects advisors from providing the very transparency that gave rise to the occupation in the primary place.
The late Charlie Munger once described an analogous problem. When asked why irrational behavior was so common within the investment management industry, he shared an anecdote about buying fishing bait in Minnesota. He couldn’t imagine how the lure’s technicolor glitter would attract fish. So he asked the shop owner if it actually worked. The owner confessed his ambivalence: “Sir, I don’t sell to fish.”
Trustees of institutional investment plans find themselves in an analogous position. They design complex allocations and buy expensive alternative asset classes and actively managed funds, despite the growing possibility that the associated fees are unlikely to provide attractive results.
So what’s the answer?
For fiduciaries, step one is to acknowledge that the businesses they depend on for investment advice are removed from conflict-free. Once they acknowledge this, they’ll open their minds to evidence that a less complex and inexpensive strategy could have advantages.
For investment advisors, step one is to let go of the obsession with portfolio complexity and the quixotic desire to outsmart ruthlessly efficient markets. Those who accept this reality will find that customers proceed to wish their services. By spending less time on unnecessarily complex portfolios, hiring and firing managers, and dear forays into esoteric asset classes, advisors can deal with long-neglected issues and restore their status as trusted advisors.
Experience shows that these changes are each priceless and achievable. Perhaps 2024 will mark the start of a brand new era in investment advice?
Photo credit: ©Getty Images / Andriy Onufriyenko
