Several decades ago, I attended a security analysts’ society luncheon that featured a talk on selecting investment managers. The speaker was from Frank Russell and Company, then and now the world’s largest investment consulting firm, so, presumably, he knew something about his subject. When question time came, I asked him how often investment managers lied to him. The audience laughed, uncomfortably. The speaker said, “Never. By the time I visit them they pretty much have their stories straight.”
I have thought about the speaker’s reply a lot over the years. Perhaps all he meant was that he almost never caught anyone lying, so how could he know? On the other hand, if the speaker meant that investment managers are invariably honest and trustworthy, then I envy him, although I doubt his competence. Perhaps this is unfair. Perhaps the world of investment managers is more trustworthy than the world of Hedge Fund and Alternative Investment managers, which is the world I have inhabited, off and on, for some twenty odd years. All I can say for sure is that I get lied to all the time and I don’t like it at all.
In at least two ways, Fund of Funds managers are tougher now than they were twenty years ago, less tolerant of lies. Due Diligence investigations are common now and, typically, the investigators are, at least, moderately competent. More important, Hedge Funds that do not provide audited results are now all but universally ignored.
Notice that both types of lie detection depend on relatively hard, quantifiable evidence. Oddly, I have seen no evidence that Fund of Fund managers use less quantifiable lie detection techniques, although, sometimes, these are the only tools available. I have seen no Fund of Fund job ads, for example, looking for clinical psychologists or FBI interrogators. To the contrary, I have been shot down several times for even suggesting that a Fund of Funds spend more time listening for lies. As “Mo”, a member of an investment committee I worked on some years back put it, “Only the facts matter. Words are not facts. Only the RORs matter.” I lost and probably deserved to lose that fight. Mo’s putdown had a nice macho ring to it that I couldn’t emulate. Still can’t.
Mo’s contempt for less quantitative skills is all but universal. Part of this contempt is justified. There are real problems here. There is no rule that lies must fail, even on average. Much worse, there are two types of possible errors here; not catching a lie and identifying the truth as a lie, which is much, much more common than we let ourselves believe. In the latter case, the Fund of Funds manager might bypass a valuable Fund manager. To the extent there is any merit in Mo’s argument, it must lie here.
But this should not lead us astray. Lies are such powerful and useful tools that people who tell lies tend to tell them often. A Fund of Funds manager who catches an investment manager lying can, therefore, reasonably assume that that manager lied to him before and will lie to him again, more likely than not when matters concern serious money. Saints have always been in short supply, of course. At one time or another, almost everyone lies, but it does not follow that the FOF manager should forgive and forget. At least not where business is concerned.
Much more important, investors do not pay us to be methodologically pure, much less to do what we want to do or even what we are good at doing. They pay us to make the right decisions. This means that when we can detect lies by quantitative techniques, by properly applied due diligence we should. This also means that if other less quantifiable techniques can give us even a small edge, they should have a place in our arsenal. The literature on lies and lie detection is immense. There are a number of things FOF managers might do. Naturally, not all of them work.
Several of the most interesting lie detection techniques are unavailable to us, for better and worse. While I can think of several Hedge Fund managers I would happily water board, I have yet to find a boss who will allow it. For similar reasons, it is hard to get most Hedge Fund managers to take a polygraph. Still, there is probably not much lost here. These techniques seem to have little value, if the evidence I have seen can be trusted. Recent research suggests that less invasive techniques such as MRIs and thermal imaging can help detect lies. For several reasons, including cost, we can’t use these techniques right now.
Several companies sell internet- or paper and pencil-based honesty tests. These test are inexpensive, easy to administer and of some value when hiring factory workers and retail sales people. Unfortunately, they are easy to game. If the test taker can figure out which answer someone who has no tolerance for lies would choose, he can pass the test. I have yet to meet an investment manager who wasn’t smart enough to game these tests.
Several firms sell voice stress analyzers, the theory here being that someone stressed is more likely to be lying than someone who is not. Unfortunately, the evidence I have seen shows that these machines aren’t very good at detecting stress. More important, stress can be caused by many things, including fear of losing an important sale. Moreover, a person who tells the same lie repeatedly eventually learns to cover his tracks and, worse, loses his fear. By the time you talk to him, he may be impossible to catch. All of this supports the position of Frank Russell’s manager or, at least, one possible interpretation of what he said.
This leaves questioning and observation as the Fund of Funds manager’s only real tools. Standard police interviewing technique is to make the suspect go over his story again and again and watch for discrepancies—another technique that is unavailable to us. Fortunately, even under fairly cursory questioning, liars sometimes let the truth leak out.
Consider, for example, an interview a hedge fund manager once gave to a certain well know investor. According to the investor, the hedge fund manager told the investor how he grew up poor and how important it was for him to win, which was exactly what the investor wanted to hear. Later, when the investor asked him where the seed money for his fund came from, the hedge fund manager told him it came from his trust fund. I had a childhood something like that myself. I was dirt poor. My tutors, my maids and my butlers hardly ever had enough to eat. My chauffeur had one shabby little outfit and had to make due with a three year old Rolls Royce. But for my single minded efforts to claw my way out of that ghetto, to earn the trust fund I deserved, I would be there now. But I digress.
In fiction, contradictions are an infallible indicator of lies, but the example above to the contrary; this is not always true in real life. In real life, people misremember, confuse one event with another. Ahem. Despite considerable effort, I can’t track down the source of the story above. Perhaps, my ‘example’ is just another bad memory.
More, while leakage is frequent in fiction, it is far less common in real life. The more types of slips the FOF manager can watch for, therefore, the more likely he is to catch a lie. The FOF manager, therefore, should listen for slips of the tongue, tirades, convoluted answers to simple questions, and inappropriate use of grammar. More, the FOF manager should listen to the HF manager’s tone of voice, and watch his face, posture and body movements. With the exception of slips of the tongue, all the FOF manager can hope to discover is the liar’s true emotions, but sometimes this is enough.
For example, “Oscar”, a trader I once knew, now manages a European Hedge Fund. Several years ago, I talked to someone who said he had interviewed Oscar as part of a due diligence review. My informant said he repeatedly asked Oscar about his track record prior to starting his hedge fund, which, according to my informant, was not listed on his disclosure document. As far as I know, nothing prevented Oscar from disclosing his prior track record other than the fact it was dismal. But Oscar just sat there, professional and composed, repeatedly saying that his non-disclosure agreement prevented him from revealing his previous returns, all the while his right hand was flat on the table in front of him, palm down, middle finger extended.
Paul Ekman, whose work on lying is the backbone of my own thinking on the subject, calls Oscar’s use of his finger an “emblem.” An emblem is a gesture, usually intended, whose meaning is clear. An unintended emblem is something like a slip of the tongue, it is such a rare and revealing event that the FOF manager can usually assume it means exactly what it seems to mean.
Oscar almost certainly did not intend to give my informant the finger. His manners are better than mine are. More important, unless he was confronted with a photograph or a movie, he would certainly deny that he had done so. An unintended emblem is one of many types of behaviors poker players call a ‘tell’, a term I would like to see in wider use. A tell is a verbal or non-verbal slip, a mistake that gives your opponent information you don’t want them to have. Tirades, convoluted answers to simple questions, particular tones of voice, and other potential tells are not rare and cannot be taken at face value, certainly not as signs of deceit. Some people just talk funny. Me, for example. The FOF manager needs to listen carefully, comparing what the HF manager says to what he knows about the HF manager’s history and the way the HF manager usually talks and behaves. For example, a HF manager who usually gives straightforward answers, and then suddenly starts giving convoluted answers when asked about what he did for a particular employer might well be lying. On the other hand, if the manager usually gives convoluted answers, this is no evidence at all.
Most lies are caught, if they are caught at all, during due diligence reviews or managerial audits. Less often, lies are caught during social events. Both venues are useful, but they must be used differently.
It is important to understand that while the Fund of Funds manager has a right to demand honest answers from the people he questions, the people he questions have no similar claim. As part of the managerial interview, the Fund of Funds manager may lie ethically as he might in the theater, in magic, in poker and for exactly the same reasons. Not incidentally, in writing this article, I have changed certain small details in some of my anecdotes in order to protect the guilty and, of course, to make myself seem more important and influential than I am.
Still, while investment managers are big boys and should be able to figure this out on their own, it is only fair to give them warning. I start my own managerial audits by saying, “I’m going to run a few flags up a few flagpoles and see if you salute. Some flags you salute. Some you don’t. Do you understand?” In the same way the opportunity to lie ethically ends when the magic show or poker game ends, this opportunity to lie ethically to an investment manager ends when the managerial interview ends.
For several reasons, going out to dinner with Hedge Fund managers is going out of style. Going out to dinner is generally an immense waste of time and, much worse, because the investment manager usually pays, it puts the FOF manager in his debt. On the other hand, if the FOF manager keeps his wits about him, he can get certain types of information from the manager it is difficult to get any other way. For example, when talking to Hedge Fund managers, I listen for any mention of marital infidelity. I have long held that a person who will lie to his wife or husband will lie to his investors. I am not positive this is true, to be perfectly honest, but within my small sample, the correlation is 100%. Not incidentally, what is important here is not your or my ethics, but the investment manager’s; infidelity does not have to be hidden by lies. If the manager has an open marriage, for example, he does not have to lie.
There is only one other circumstance I know of where lying to an investment manager is ethical and that is where you don’t lie, not exactly, you disinform. Disinformation is a technical term from espionage and refers to hiding something where you know the black hats will find it. Several decades back, I suspected that one of my, let’s call him a supplier, had tapped my phone. In a conversation with someone back in the states, I mentioned that I thought my supplier had a Mickey Mouse approach to the business and that I frequently wore my Mickey Mouse tie to meetings with him to show my disdain. I wore my Mickey Mouse tie the next time we met and when he saw it, he frowned. Someone more mercenary than I am would have used that phone conversation to set him off on the wrong track, to let him know that my minimum price was way above what it really was, for example. I like to think of myself as one of the good guys; I regret every small dishonesty in my less than sterling life. I also regret that I didn’t treat that man the way he deserved.