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Does an Investment Manager Have to Make Sense?
Perhaps because of our need for certainty, current fund of funds industry practice is to ignore hedge fund managers who cannot explain what they are doing or worse, do a bad job explaining.Current practice is legally safe and, let us say this quietly, emotionally and intellectually satisfying.Who doesn’t enjoy being one up on someone else?It’s another question, however, whether this approach makes investment sense.
On the one hand, there are strong reasons to take this approach seriously.A FOF manager who demanded that his hedge fund managers supported their results with a viable theory would never fall for someone like Joseph Jett.Mr. Jett was a trader at Kidder Peabody and, apparently, a very successful trader.Unfortunately for Kidder Peabody, which lost hundreds of millions on Mr. Jett, Mr. Jett’s profits were more apparent than real.Mr. Jett gamed the system.If the news reports on Mr. Jett and Kidder can be trusted, Kidder Peabody executives never found it necessary to understand the theory behind Joseph Jett’s trading.Where exactly did Mr. Jett’s profits come from?Why wasn’t anyone else making money this way?Kidder’s management believed in supermen and they believed they had hired one.Kidder Peabody executives never put enough effort into understanding Mr. Jett’s system.Why bother?Profit is proof.
On the other hand, the arguments above assume that the fund of funds manager can recognize a viable theory when he sees one.I’ve met enough FOF managers to have real doubts about that.For example, Harry Markowitz’s invention of portfolio theory is the single most important innovation in the entire history of finance.And yet, at Markowitz’s oral exams for his PhD degree at Chicago, even the great Milton Friedman brushed off this work as neither economics nor mathematics, without in any way acknowledging the profound and far-reaching significance of Markowitz’s achievement.This does not bode well for the rest of us.
Part of the problem is that while phony breakthroughs happen almost daily, real breakthroughs are typically separated by decades.This makes it hard to keep sharp the skills that help you separate the real breakthroughs from the phony.The only group that I know of that works on these issues continuously are science fiction readers and writers.
Worse, compared with other disciplines, investment professionals tend to be incredibly dogmatic.Some years ago, I was a consultant on a large research project that compared one drug that suppressed the autoimmune response with another almost identical drug.I remember the head of the project saying that the reason that the two drugs behaved almost identically was because chemically they were identical.One drug was better because its formulation put more of the active chemical into the bloodstream faster.Then he hedged and said that, at least, they thought that was the reason.I don’t know a single investment professional who would make such a modest statement, especially when years of work and hundreds of millions of dollars had already been spent on research.I would almost certainly have made a stronger statement myself—but then I’ve spent many years in investment research.When we venture into the halls of science, which some of us do, on occasion, it would, perhaps, be best if we wore a leper’s bell around our necks and had someone run before us shouting, “Unclean!Unclean!”
In a sense, current FOF industry practice is a low risk approach to selecting hedge fund managers.If my own experience evaluating hedge fund managers can be trusted, the argument for understanding a hedge fund manager’s methods is actually stronger than the example above implies.I believe that a FOF manager who demands a viable theory from his hedge fund managers will avoid at least 85% of all investment frauds and at least 20% of all incompetent hedge fund managers.
If a manager doesn’t know why his method works that means he does not know why his method works—and nothing else.There are two big problems with placing money with such a manager.No, sorry, there are two immense problems with putting money with such a manager.First, if the manager doesn’t know why his method works, how is he going to know when it will fail?A manager who has a strong theoretical rationale often knows when a method should fail—and can be somewhere else when that happens.A manager whose only justification is empirical will not be able to avoid such errors.Second, and much more important, if a manager doesn’t have a rationale, that doesn’t mean that a rationale is not important.It means that developing the rationale, if one can be developed, is the FOF manager’s responsibility.There are a lot of competitive activities, like singing and sports, where theory plays little part, where knowledge of theory does not give any advantage.It is not stylish these days to claim investment management is an art, quite the contrary.But that does not mean that this is not a viable argument—at least for some managers.More important, it does not mean that an ‘artistic’ investment approach cannot be analyzed.I know of no art or sport that cannot be broken down into individual skills.For example, John Gardner breaks fiction writing into eight skills, each of which can be analyzed separately.If a FOF manager believes his hedge fund manager is an artist, he needs to know which skills his art demands and whether his artist has them.
Alternatively, the hedge fund manager may have found a genuine anomality, a real phenomenon for which there is no current theory.This is rare but important.In fact, all major advances in science occur when something that cannot happen does or something that must happen does not.A genuine investment anomality will generate high profits with low risk.Of course, most non-investment anomalities turn out to be nothing more than dirt and noise and error.So do most investment anomalities, come to think of it.
There is a cost for following FOF industry practices here and a cost for ignoring them.To invest with theory-less HF managers is to risk investing with frauds and Bozos.On the other hand, requiring a viable investment theory filters out exactly those managers who can be expected to make the most money.The investment industry is thick with wannabes and hanger-ons.The success of someone who makes their money on technique is relatively easy to duplicate.This is why investment success starts dieing as soon as it is born.The success of someone who owns a genuine anomality or someone who has a rare and important skill, on the other hand, may be impossible or almost impossible to duplicate.
The FOF manager’s choice here depends on who he is or, at least, on whom he thinks he is.The theory of contrary opinion, which is the single most logical investment theory we have, implies a number of things here--all of which are nasty.For example, it implies that the theories that are most likely to make money are the ones we are least likely to recognize.It also implies that someone who really can recognize a valuable trading method will have, how to put this kindly, a rather peculiar set of psychological skills.The theory does NOT demand high intelligence or investment wisdom or experience.The theory demands a certain churlishness or insolence; it demands someone who could not care less what is popular or stylish.Much worse, it sometimes demands enough self-knowledge and discipline to write off decades of work when it finally becomes evident that other are doing what you alone could once do well.For those who cannot do this, and that includes the vast majority of FOF managers, it is probably best to stay with managers who make sense.
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