Practical analysis for investment professionals
07 October 2015

Better Investment Consulting Is Long Overdue

Better Investment Consulting Is Long Overdue

If history repeats itself, I should think we can expect the same thing again. — Terry Venables

Every year numerous studies by S&P, Vanguard, Morningstar, and others report that the vast majority of active managers fail to outperform their passive counterparts. What explains active investing’s underperformance vs. passive investing over the last several years? And why do investors continue to hire active managers?

In his popular book What Investors Really WantMeir Statman explains that investors want to play the investment game and they want to win. They believe their investment advisers can identify skillful active managers. Yet, unfortunately, history does repeat itself: Active managers consistently fail to earn their fees year after year.

What can change this pattern of repeated failure? Investors need to demand better due diligence to separate out the losers. Intermediaries must improve their manager research. The search for skill continues to be conducted with the same lazy tools that have never worked in the past and never will in the future. It’s like the allegory of the drunk and the streetlamp: The drunk loses his keys at night in a park across the street, but he looks for them under a nearby streetlamp because it’s easier to see.

Antiquated Evaluation Tools

The old performance evaluation tools are indexes and peer groups. These are awful barometers of success or failure. Indexes don’t work because many skillful managers don’t live in style boxes, nor do they hug indexes. Peer groups don’t work because they are loaded with biases and are comprised of losers since most fail to outperform their benchmarks. Beating the losers does not make a winner. Peer groups of hedge funds are exceptionally silly because hedge funds are unique, so by definition they can’t be grouped together: “Unique” means without peer. Hedge fund peer groups epitomize classification bias because the members don’t belong together. (For further details, see “The Compelling Case for Changing Hedge Fund Due Diligence.”)

Investment management consulting is a fungible credence good: a service that is difficult if not impossible to properly assess before or even after consumption. Credence good markets emerge when sellers are much more knowledgeable than buyers. This fact has propelled so-called “robo-advisers” into the limelight, because if you can’t tell the difference, you might as well buy the cheapest.

Clients (buyers) need to wise up. There’s a good reason why active managers selected by consultants fail to deliver value add: Consultants aren’t trying hard enough because they don’t have to. This laxity applies to advice-only consultants as well as outsourced chief investment officers (OCIOs). It would be better to not pretend at all. That’s why intellectually honest robo-advisers have given up on the search for skillful active investment managers.

Competent consultants earn alpha by abandoning the old ways and stepping up to contemporary due diligence. Investors pay for competence: They should demand it.

Contemporary Due Diligence

The odds of actually finding skill can be improved with custom benchmarks and scientific peer groups. Custom benchmarks address the make-or-buy decision. We can replicate (i.e., make) most managers inexpensively with blends of exchange-traded funds (ETFs) long and short, as determined through custom benchmarking approaches like style analysis or factor exposures.

Scientific peer groups, or universes, use hypothesis testing to determine if performance in excess of a custom benchmark is statistically significant. The hypothesis “performance is good” is tested by comparing the manager’s actual return to the returns on all the portfolios the manager might have held by following their portfolio construction rules and using the eligible stocks. It’s a portfolio simulation.

In its benchmark subcommittee report, CFA Institute recommends custom benchmarks and cautions against the use of peer groups. Custom benchmarks are a good suggestion, but they come with a particular problem: It takes many decades to establish statistically significant alphas with custom benchmarks. Scientific universes solve this waiting problem by testing the hypothesis “performance is good” in the cross-section of all possibilities, whereas alpha tests this hypothesis across time using regression analysis.

Demand Better and Consolidate the Best

Clients need to learn the difference between haphazard and assiduous due diligence, between pay-to-play-based and objective recommendations. In other words, clients need to research and understand consulting processes so they can get what they pay for.

In the research post “There Are Too Many Active Managers,” Towers Watson theorizes that active managers should constitute only 30% of all managers rather than the firm’s current estimate of 80%. This realignment would be more cost effective for investors and would continue to keep markets efficient. Put another way, active management should mostly fade away but not die out altogether.

A reduction in the number of active managers will happen naturally if clients insist that intermediaries (consultants and fund-of-funds) actually figure out who’s good and who’s not. Then Darwinian principles will prevail, so only the fittest will survive. Clients hire intermediaries to perform a talent search, but that fails because the processes remain in the dark ages. Contemporary manager due diligence could change all that and condense the active manager pool down to just the most worthy. Advisers who are looking for ways to compete against robo-advisers should wave the contemporary due diligence flag as an important differentiator, especially its potential for outperformance.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Ron Surz

Ronald J. Surz is president and CEO of PPCA Inc. and its division, Target Date Solutions. He is a pension consulting veteran, having started with A.G. Becker in the 1970's. Surz earned an MBA in Finance at the University of Chicago and an MS in Applied Mathematics at the University of Illinois.

8 thoughts on “Better Investment Consulting Is Long Overdue”

  1. James Tharin says:

    This is just another article bashing active management. There is nothing new here, only a recycled list of items that are open for debate. I obviously do disagree with the notion that passive investing is superior to active management – and vica versa. Honestly, I don’t think its an either / or argument. Passive investing is merely another style – like growth or value, etc. and indexing should be treated as part of an over all asset allocation. The notion that anybody has a lock on the best way to invest for all people in all market cycles and of all risk tolerances is absurd and arrogant. For example, how’s that index fund working out for you this year? And oh by the way, where should I index next year?

    The bigger issue though, in my opinion, is why CFAI chooses to aggressively discredit its constituents – financial analysts. If the constant barrage of articles espousing passive management and the strict view that EMH always holds is the point of view of this organization then why don’t we go ahead and shut it down, or at least change the name to something that better reflects the ideals that are being promoted. I don’t think I would have taken those three exams, paid dues for fifteen or twenty years and participated on the local Society boards to the extent that I did if I knew that CFAI would become this belligerent towards its members.

    1. David says:

      Please read the article more closely. The author is pointing to those who profess to have expertise in selecting active managers who will outperform. He is not making negative comments about CFAs.

      A colleague and I did a study in the early 1990’s on “Do Winners Repeat?”, etc. and found that outperformance tends to be a short term phenomenon peaking at approximately 12 months. There are lots of well known reasons for this.

      Ask a investment management consultant if he has any record of his performance in selecting managers. Ask him to specify his criteria for selecting and replacing managers. If he cannot provide evidence of an effective discipline with a performance record to document good performance, why bother? Most often the investment management consultant will conduct what amounts to a beauty contest, invite the client to choose, and if the choice turns out badly the consultant blames the client.

      If I am wrong I would welcome the evidence.

    2. Rob Gowen says:


      Thank you for your comments and an extra thank you for your membership. We certainly do not intend by any measure to take the stance of actively discrediting active management. If that is your impression, then I’m very interested in discussing the matter with you – we are here to serve the membership and advocate heavily for all investors so they can receive the best outcomes possible. Over the years our CFA program curriculum has evolved significantly and we have readings dedicated to behavioral finance and even technical analysis so we are most definitely not pushing EMH as the only answer.

      I can understand why you feel active management is under fire. It’s easy to throw rocks at active managers for many reasons. One can make the case that “heads passive wins and tails active loses” because the industry does not have the best reputation at the moment.

      I have worked for CFA Institute for over 8 years and I came from practice (active buy side equity). Internally, there are many die hard fundamental analysts. The organization believes in it and at the same time, we want an open and honest debate. If we are short changing the active side, we’ll look to change that. The Enterprising Investor is a place where we encourage people to state their opinions on a forum that doesn’t necessarily represent CFA Institute’s official stance on the industry.

      We do have content across a few of our publications that shines positive light on active management. Again, we try to be brokers and curators for insightful content. We have not turned away content related to defending active management at all and I hope we receive many submissions in the future.

      I could ramble on as I find this issue important and frankly very intellectually appealing! My main concern is that I did not want to leave your comment unanswered by CFA Institute. We appreciate any and all feedback and perception matters. If you want to have a chat, feel free to reach out to me. The main number for CFA Institute is 434-951-5499.

  2. James Tharin says:


    Thanks for your comment. Evidence supporting the value of active management can be found here:

    Also feel free to google ‘active share’.

    I understand that your study or your point addresses picking managers vs supportinag passive management. Picking active managers is a form of active management in my opinion although I personally do not perform this role. We can all find studies that support our belief system. However, I still contend that the conversation out of CFAI and its periodicals has become increasingly hostile towards active managers. I further don’t believe that most of it is justified. I also think that this particular article is an example of that. Just look at the author’s job description by clicking on his name at the beginning of the article.

    If you want to know why I have this opinion just casually browse through the articles in the Enterprising Investor blog or the Financial Analyst Journal. Many of those authors make a lot of money pushing the passive side of the debate. Many of the academics have never worked with clients.

  3. James Tharin says:


    Thanks for your reply. I look forward to talking with you about the concerns I have regarding my perception of CFA Institute’s position by telephone.

  4. Ron Surz says:

    Thanks for all your comments, but they’re off the mark. This is NOT an article about “Passive Wins.” It’s about the failure of advisors to do their jobs, mostly because they don’t have to if they all stick together and stay lazy.

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