Reasons to Hire an Institutional Investment Advisor

by | bytesize, Defined Contribution, Investment

Many defined contribution retirement plan sponsors choose not to work with an institutional investment advisor – that is, one focused on retirement plans. In this note we explain why unadvised plan sponsors could be patsies in the game of picking skilled active managers: the pros are likely eating their lunch.

First, the Employee Retirement Income Security Act (ERISA) requires that fiduciaries, such as plan sponsors, act prudently. The Department of Labor (DoL) says prudence requires acquiring “expertise in a variety of areas, such as investments.”¹  If you lack the expertise to act as a “prudent person” would, the DoL urges you to hire an expert. This is because the DoL recognizes that picking investment managers is very hard.

Second, active management is a “zero sum game.” This means that one manager’s outperformance relative to a benchmark comes at the expense of another manager’s underperformance. There cannot be winners against a market cap weighted benchmark without losers. When you use active management, you are in competition with other investors. Unlike selecting index funds, selecting active managers requires skill.

Third, institutional investment advisory firms have sizable teams of research professionals on the hunt for managers with an edge. They are deeply knowledgeable and experienced. They have skill.² They are the pros. And they are your competition if you are trying to pick active managers or if you are acquiescing to the investment “suggestions” of your recordkeeper – more on this point below.

It follows from these points that if you are unadvised, you are at a huge disadvantage and should probably just use passively managed, or index funds.³ There’s no shame in admitting that you can’t compete with the pros. In fact, it’s the prudent thing to do.

And finally, don’t be misled: your recordkeeper’s investment serviceperson is not your investment advisor. They are not liable, as fiduciaries, for the “guidance” (not advice) they provide. And they are ultimately not responsible for the investment performance of your managers. If you are relying on your recordkeeper, you are unadvised , you are competing against the pros.

This leaves you with two real choices: index or hire a pro.

¹DoL, “Meeting your Fiduciary Responsibilities,” 2012.

²AQR, Active and Passive Investing – the Long Run Evidence, Alternative Thinking 2Q2018

³An index fund is subject to the same prudence requirements as other investments, and must be chosen according to an informed and well-reasoned process, as must deciding which asset classes to offer, also a challenging task.

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