The Investor's Paradox: The Power of Simplicity in a World of Overwhelming Choice

Introduction

The Trillion-Dollar Job that No One Talks About

An expert is a person who has made all the mistakes that can be made in a very narrow field.

—Neils Bohr

Few visitors to Clifford Street in London’s tony Mayfair neighborhood would find much to remember. It is narrow and short, with an uninterrupted row of stately but unremarkable low-rise buildings, perhaps most relevant for cabbies ferrying wealthy shoppers between the jewelers on Bond Street and the clothiers of Savile Row.

Once mostly residential, Mayfair has seen many of its homes converted into offices, and even centuries-old structures demand some of the highest rents in the world. Art, commerce, and cuisine are welcome endeavors in Mayfair, but it is the power of finance that courses through the labyrinthine district. Behind these nondescript doors are some of the world’s most secretive and prosperous wealth managers, private banks, and hedge funds.

Clifford Street’s lack of noteworthiness stands in contrast to the gravity of wealth resting on the other side of pale-brown stone facades and weathered white porticos. When I first turned the corner onto Clifford Street in the fall of 2005, my job was a combination of talent scout and financial analyst, charged to find good portfolio managers to whom my firm could allocate capital on behalf of our clients, which were mostly conservative pension funds and other large institutions. Because our average investment was very large, we held the skeleton key to enter every locked door in Mayfair and beyond.

On that particular day, I was responsible for leading the due diligence on a so-called event-driven hedge fund, meaning that they took bets on the likelihood of mergers, acquisitions, and other corporate restructurings. We had already vetted the firm’s New York–based associates, and it had gone well, so my boss and I flew to London to meet the other key principals. Upon arriving, we were escorted into a room that looked suited for a law school seminar, with wainscoted mahogany walls and a large, worn conference table.

Over the past fourteen years, I have conducted something like 4,000 interviews with portfolio managers and other investment professionals. Sometimes we meet in person, sometimes over the phone; sometimes it’s one conversation with a single person that lasts less than an hour, other times meetings with an entire team fill a whole day; sometimes hundreds of millions of dollars are on the line, other times it’s a casual coffee to get to know someone better. This particular session in Mayfair was to be nothing out of the ordinary. We would review the background of the principals, the market opportunity, and the details of their investment process.

Instead, it was a train wreck—the worst due diligence session I have ever conducted. The meeting started harmlessly enough. The lead portfolio manager arrived in his Mayfair uniform: fitted dark suit, understated tie, posh accent. But after some opening pleasantries, the conversation went awry. It turned out he was less interested in a dialogue than in regaling us with heroic stories of trading conquests. Even at that early stage in my career, I could usually corral an egotistic fund manager back on track, but for some reason that day, I was inept. My questions were indirect and open-ended, which only let him bloviate more. My feeble attempts to redirect the conversation failed. After a certain point, it felt like a conversation with Charlie Brown’s teacher, all intonation and no words. My boss opted not to intervene. As things went steadily south, I sensed him sliding lower in his chair. Finally he just left; I can’t recall if he actually needed to be somewhere else or just needed to not be there.

I’m still not sure why things went so poorly. Perhaps I was unprepared; overly deferential to a glib professional; intimidated by the watchful proximity of my boss; or just jet-lagged. Whatever the reason, this failing wasn’t trivial. We had flown thousands of miles at great expense to vet this investment. Our firm was in steep competition with other global allocators to source great talent. Wasted meetings weren’t an option, especially overseas.

When it was finally over, I stepped back out onto Clifford Street, thankful for some fresh air and oddly in good spirits, just knowing it was over. The rush was short-lived. In reviewing my notes, I realized I had barely any of the answers we needed in order to decide whether we should invest. This was an enormous waste of resources. And there are no do-overs in this game. Shortly thereafter, at a coffee shop down the block, I reconnected with my boss. At first, no words were spoken. Just a look. That was a disaster, I muttered. After a pause, he responded, Yes. Yes it was.

No one grows up wanting to do fund manager research. Of all the lofty and interesting career aspirations that I recall from my youth and that I now see with my young children—fireman, astronaut, comic book illustrator, Pittsburgh Steeler, princess—the vocation of outsourcing investment discretion to professional money managers never figured. There are plenty of tales about young folks who developed an early passion for picking stocks. But this is something different. I suspect that no child has ever dreamed of doing the task to which I’ve devoted my career.

Fund managers—like those from firms like Fidelity, JPMorgan, Bridgewater, Fortress, and thousands of others—manage money on behalf of their clients. Fund managers pick securities, mainly stocks and bonds. How they do so is the stuff of conventional finance.

By contrast, fund investors pick people, not securities. How to buy and sell people is a square peg in the round world of finance because people aren’t tickers. They lack audited financial statements, and they don’t vary in price from moment to moment (which isn’t to say they’re not volatile). People are riddled with behavioral biases, and they often don’t act in ways that would be objectively considered rational. In finance, quantitative metrics might be open to interpretation, but they don’t lie. People can and sometimes do.

This is a book about making good investment decisions—of a particular kind. Few of us actually build our portfolios by directly selecting individual stocks, bonds, commodities, currencies, or other securities. Instead we turn to experts—to fund managers—to help us navigate complex markets. But even choosing those experts is fraught with difficulty. There are countless books and seminars on how to pick stocks and bonds; not so for choosing the right experts.

I have now spent a good majority of my career trying to pick winning fund managers. As a researcher at firms in both the traditional (mutual fund) and alternative (hedge fund) industries, I have vetted thousands of managers, overseen multibillion-dollar portfolios of underlying fund investments, published dozens of articles praising or panning specific managers, and collaborated with scores of talented analysts. The job has taken me to every corner of the globe, from tiny outposts in Mumbai and Oslo to the tallest skyscrapers in New York, Hong Kong, and Tokyo. There have been plenty of successes and plenty of setbacks along the way; I have made many mistakes. Both disappointing and edifying, the episode on Clifford Street was one of many exercises in the peculiar art of fund manager selection that informs my perspective today. Indeed, we all know how to get to Carnegie Hall.

Based on my experience, the genesis of this book was an attempt to make sense of what I believe to be two big shifts in the world around us. First, in the aftermath of the 2008 global financial crisis, markets appear to have changed. My and my parents’ generations benefited greatly from a nearly thirty-year bull market that kicked off in the early 1980s. Many serious analysts now suggest that the future won’t resemble the past. I agree. While it was never easy, the strong headwinds now facing the investor class are arguably unprecedented. Second, the playbook has changed. Investors have an increasingly broad and complex set of investment choices before them—including the explosion of accessible hedge funds onto the scene—in order to succeed in this new world order of money management. We might think that serious challenges call for new and powerful tools, but as the old saying goes, be careful what you wish for.

It is this intersection of dangerous markets and overwhelming choices for which I aim to provide some useful guidance. To do so, I leverage a concept I’ve coined called the investor’s paradox, which speaks to how difficult it is to actually choose the right investments in light of the broader forces at play. In particular, we desire an abundance of choice—but often find it defeating. As well, we feel compelled to tackle complex challenges with sophisticated solutions—but frequently find them disappointing.

Unlike many treatments of investing, the source of my guidance stems less from the strictures of finance than from the insights of behavioral psychology. The modern paradox facing investors—ranging from big institutions overseeing billion-dollar portfolios to the everyman tending to his nest egg—is part of a broader challenge on how to make good decisions. Indeed, one of the most important insights of the behavioral and cognitive sciences is that happiness occurs when outcomes meet our expectations. Likewise, much of investing success is about appropriately managing expectations, yet this is informed by adaptive human behavior more than by technical treatments of stocks or bonds. Square pegs don’t fit round holes.

An Oddball Career

My nonlinear career path strongly influences the forthcoming narrative. In retrospect, it seems that I entered the financial markets at the beginning of the end. In early 2000, as I moved from academia to Morningstar, the shop that basically invented the field of manager research, the stock market experienced the start of a prolonged decline. Arriving at the end of a party is rarely fun; I was able to cut my teeth by analyzing managers and fund complexes just as many of them fell into steep decline. It was not only the highfliers of the period such as Janus, Putnam, and AIM that took it on the chin; even the most respected firms struggled to protect their clients’ investments. Many investors not only lost their nest eggs; they grew anxious and confused about what to expect next. It was the beginning of a lost decade for many investors, when stock markets returned just about nothing.

I was too far immersed in the weeds of interviewing portfolio managers day in and day out to truly appreciate some of the broader forces at play. Within the context of the traditional mutual fund—long-only, fully invested, narrowly focused, and mandated to beat a benchmark rather than make money—I tried to assess whether a fund manager was good at picking stocks, managing risk, and delivering good performance. In retrospect, my task amounted to dancing on the head of a pin, exploring issues of focus, skill, and returns, when in fact the imposed constraints of traditional structures largely predetermined the results.

Meanwhile, in the same decade, those investors who experimented with so-called alternatives generally survived well, even earning big profits during the 2000–2002 bear market. By coincidence—pure luck, really, since I hadn’t yet caught on to the emerging paradigm shift—I left Morningstar to become a hedge fund analyst with Mesirow Advanced Strategies, a well-regarded fund of hedge funds. Funds of funds specialize in identifying good hedge fund managers, building portfolios of them (hence the literal name, fund of funds), and monitoring their activities, all with the aim of delivering clients good returns. That firm, along with other sizable peers (e.g., Grosvenor, Harris Alternatives, Glenwood), established Chicago as one of the premier global hubs for hedge fund investing. At peak, there was probably around $60 billion of funds-of-funds capital parked within a few blocks of Lake Shore Drive.

At that time, hedge fund strategies were just beginning to attract massive amounts of capital from serious institutions like pension funds, insurance companies, and foundations. Teachers’ unions, hospital endowments, and corporate pensioners became increasingly reliant on investing in the right hedge funds (whether their constituents knew it or not). As a result, high-quality groups like Mesirow grew exponentially in just a matter of years.

I was not alone in my accidental vocation. There are hundreds of thousands of professional investors and financial advisors worldwide who spend a good chunk of their time researching, selecting, and monitoring money managers—from traditional mutual funds to more complex hedge funds. Massive sums of capital get allocated and reallocated by professional fund pickers. At present, roughly one-third of the investments in the

$2 trillion hedge fund industry flow through the fund-of-funds vehicles executed by a profession that until recently few had ever heard of. Meanwhile, investment consultants now advise on trillions of dollars of manager allocations. And more recently, many end investors—pensions, endowments, insurance companies, sovereign wealth funds, and so forth—are now looking to bypass these intermediaries and go direct. They are bringing professional fund picking in-house.

Yet manager research remains a curious and largely unknown profession. There are virtually no college or MBA courses on the topic, in stark contrast to the endless seminars on equities, fixed income, or portfolio theory. There are few good books on the topic, but many compelling texts on securities analysis. Though there are many skilled talent scouts, it’s hard to point to industry stars. On the annual registration form for the prestigious Chartered Financial Analyst (CFA) certification, there is no box to check to indicate that you pick managers for a living. And the profession certainly does not pass the cocktail party test; ever try telling a stranger in a noisy room you work at a fund of funds?

This book illuminates this practice of manager selection, a task both important and obscure. And because the challenge is not reserved to professional advisors but is for anyone serious about their financial future, I believe the investor class is under assault by an overwhelming, sometimes intimidating, set of choices. When you add up the available mutual funds, hedge funds, exchange-traded funds (ETFs), and other managed risk pools, we are confronted by tens of thousands of potential opportunities. The investments business is a consumer products business like any other. Many of its design labs and factories are churning at full capacity.

This journey from academia to Morningstar to the world of alternatives directly informs the argument and themes inside The Investor’s Paradox.

One Approach

Convergence is upon us. The once-distinct traditional and alternative investment worlds are colliding rapidly. Traditional asset-management firms, fighting shrinking margins on their core businesses, are building new forms of investment risk that can be packaged and sold at premium margins. Meanwhile, hedge fund shops, generally tiny in comparison, see massive yet untouched markets that can be potentially accessed by delivering more investor-friendly structures. Alternatives are going mainstream, and fast.

This convergence means more choice for everyone in the investment community. That’s not necessarily a good thing. In response, The Investor’s Paradox offers a singular framework for choosing the right investment experts, independent of labels or investment styles. Indeed, my gigs at Morningstar and Mesirow were analytically identical, despite the appearance of being quite different. Both involved researching money managers in order to distinguish winners from losers. The only difference was the breadth and complexity of the strategies under scrutiny, not the general process of due diligence. In addition to simplifying our investment decisions, this unified approach allows us to calmly demystify hedge funds, which are largely misunderstood, not only by the popular media but also through much of the financial community.

Success through Simplification

Attempting to pick funds that consistently outperform others is futile. Just as there’s little evidence that even seasoned stock pickers can beat the market, there is no evidence that fund pickers can regularly pick winners. While outperforming other well-informed talent scouts is unlikely, finding and selecting the right fund managers for a particular purpose is quite possible. This is accomplished by recognizing that out of the seemingly countless items that clutter investment decisions, there are actually just four core issues that should drive our quest for the right experts:

Trust

Risk

Skill

Fit

The Investor’s Paradox is built around unpacking these items, especially the first three. It is then incumbent upon us to establish and adapt our expectations across these dimensions. Finding simplicity isn’t necessarily easy, but the effort will be rewarding. This is a message of empowerment in a daunting age.

Method Matters

In an attempt to make systematically rigorous choices, method matters more than content. Prior to my markets career, I earned a PhD from the University of Chicago, where what I researched and taught was less relevant than how I was taught to pose questions and answer them. Endless information gathering without a method to structure it is akin to drinking from a fire hose: you are much more likely to end up a sopping-wet mess than slake your thirst. In the world of investments, the fire hose of data is inexhaustible, which is why storytelling often passes for real