01. Now more than ever, managers matter

The modern era of investment management, which began in the early 1980s, has had three phases. In the early period, there was an extraordinary bull market in stocks and bonds during which simply being long in the market was the smart move. The second phase began with the bursting of the tech stock bubble in 2000 and continued through the 2008 crisis. As the bull run in stocks petered out, investors began to grapple with various models for the right way to allocate during a time of heightened uncertainty and anxiety. Institutional investors in particular began to experiment with alternative strategies that appeared more resilient than traditional long-only strategies: The modern hedge fund industry was born.

Post-meltdown, we entered a third phase in which institutions and individuals alike grappled with the right way to meet their objectives in light of heightened fear and a proliferation of choice. Alternative strategies have become available to the mainstream; the prevalence of so-called liquid alternatives is growing rapidly.


In this period of uncertainty, investors are experimenting with different solutions. What’s clear is that the exercise of picking the right managers—of outsourcing investment discretion to the experts—has grown more difficult. Yet in a market environment that is generally trendless and choppy, the choice of fund manager matters more than it does when markets generally march upwards; manager selection matters more during tough times.

02. Whether with mutual funds or hedge funds, the trick to choosing a manager is to establish your expectations.

The middle of the previous decade was the golden age of hedge funds, a short period of such intense wealth accumulation that it will long be considered a distinct moment in global financial history. With roughly a trillion dollars in new assets raised during this brief span, there was a veritable orgy of buyers and sellers often coalescing at lavish private investment conferences held in exotic locations. Increasingly, union pensioners, college endowments and charitable foundations were the beneficiaries of hedge fund prowess.

Alongside this new activity, the hedge fund industry went through its first major wave of institutionalization. As hedge funds increased in size, they grew more professional, sophisticated and to some extent bureaucratized. And much larger: By the start of 2007, there were 33 firms managing in excess of $10 billion, a far cry from just a few years prior.


But in aggregate, the performance of most hedge fund strategies was not noteworthy during this stretch. The average hedge fund underperformed in three of the five years between 2003 and 2007, and underperformed overall. The top performers posted impressive returns, while the bottom hedged equity managers lost money when traditional equity and fixed income markets climbed higher. The reason isn’t complicated; most hedge funds hedge. Traditional, benchmark-constrained investments typically capture a large percentage of their markets’ upswings and downswings; with hedge fund returns, however, on average the lows aren’t as low and the highs aren’t as high.

The market tumult of 2008 bears this out. Traditional fund managers delivered—predictably—market performance. In the context of the S&P 500 Index declining 37 percent that year, the average long-only “large blend” mutual fund declined 37.8 percent. In other words, the average large cap mutual fund more or less mirrored the market’s losses.

Alternative strategies, however, performed on average much better than the overall market. While the average large-cap mutual fund was down 37 percent, the average hedged equity fund was down only 15 percent. Other strategies, such as distressed debt or convertible arbitrage, performed worse but still beat the market. Some strategies that bet on moves in interest rates and sovereign debt delivered positive returns.

As with any data, there’s no objective analysis of these numbers. For some people, alternative investors are understood as “absolute return” vehicles that should not lose money. From that vantage point, any losses are condemnable. In my view, that’s unfair. The reality is that many alternative investors took steps to protect capital during this bear market, whether it was short equity, short credit or long volatility. And some actually did a fine job.

The most important point is this: The reason for unsatisfactory outcomes in investing is simply that outcomes do not meet expectations.

If your expectation is that a fund manager should never lose you money, then it’s fair to be disappointed when they do. But is it fair to hold that expectation in the first place? The tough thing about alternative managers is that the process of setting expectations of what they will do and how they will perform is much harder than it is for traditional managers.
The first step in investment research is establishing expectations for how the manager will run his program—both his portfolio and his business. What are the rules of the road? We should strive to state our expectations as testable hypotheses, meaning that there are observable, measurable data to collect. And by hypotheses we mean that we are looking for conditional outcomes. Under what conditions do we expect the manager to do certain things? For a global macro fund, for example, we not only want to know how much of its portfolio will be exposed to commodities but under what market circumstances it will vary its exposure. Generally, we’re asking under what circumstances a manager will make certain choices.


The “first law of manager due diligence” is that the less constrained a manager’s mandate, the more difficult it is to set expectations.

03. The questions to ask before choosing a fund manager.

I believe there are four basic questions that structure investment due diligence. These are the topics on which we form expectations about the experts we hire:

Trust · Risk · Skill · Fit
By focusing our inquiry on these areas, we can find simplicity in a world of overwhelming choice.

Can i trust you?
No single investment can make your portfolio, but any single investment can break your portfolio; one bomb can ruin your entire firm. Just ask the professional investors who invested with Bernie Mad off. Yet the evaluation of trust is more than a forensic analysis reserved for accountants, lawyers, regulators and other specialists in what has become known as “operational due diligence.” At a deeper level, it is a tricky psychological engagement to size up others as potential long-term partners with whom we have a true alignment of incentives.

What do you do?
If you had only one question to ask a fund manager, this would be it. If you walked into his office knowing literally nothing about him, simply started the conversation with “What do you do?” and engaged him with the appropriate follow-up questions, you could more or less establish all the core investment expectations for the fund at hand. Not that this is an easy task: Sometimes the risks a manager is taking are obvious, but often they are not.

Are you good at your job?
Is the expert you hire skillful? In finance, there is a conventional notion of alpha that captures outperformance relative to well-defined benchmarks. This is a useful but narrow concept. In the real world of selecting managers, the dynamic of what counts as a satisfying arrangement moves well beyond sterile, statistical analysis and enters a realm of social engagement of managing expectations. Skill is about keeping one’s promises.

Are you the right fit for me?
The question of fit is an orange compared to the previous three apples. We have been asking questions directly to or about the manager, but now we’re asking more personal questions: What is my objective? Some investors want a hedgehog—a fund that does one thing and doesn’t veer from its mission. Others want a more flexible offering with more degrees of freedom—a fox.

04. When choosing a fund manager, don’t chase performance.

Readers may note one surprising omission from these four questions: performance. If there’s one topic that everyone thinks and talks about, it’s returns. This makes sense; returns are the “product” for sale. So why the omission? It’s because performance-chasing doesn’t work. Like a sugar rush, great returns feel good for a while and then dissipate as a manager can rarely consistently meet or exceed our performance expectations. Still, we want to be with a winner, so we gravitate toward those who have generated strong recent performance. Yet buying high and selling low is a losing strategy.

I believe that in turbulent times true investment success begins with ourselves. We struggle to overcome our built-in biases, look to experts to help solve problems and hope to eventually find the right path forward. If that path involves choosing the “best” managers and trying to “beat the market,” we will fail. If we take sober stock of the problems each of us, as individuals and institutions, are trying to solve, the chance of success grows considerably. Sometimes what’s good enough is just perfect.

From The Investor’s Paradox by Brian Portnoy. Copyright (c) 2014 by the author and reprinted by permission of Palgrave Macmillan, a division of Macmillan Publishers.