Thursday, September 25, 2014

See Ya Later, Allocator

A recent episode of Freakonomics discussed a paper by Bronnenberg, Dube, Gentzkow and Shapiro that showed that informed consumers of headache remedies (such as pharmacists) were less likely to pay extra for national brands, preferring store brands and generics. BDGS suggest therefore that "misinformation explains a sizeable share of the brand premium for health products." In other words, those who are better informed can see past the veneer of marketing, and more accurately assess the quality of a product. Towards the end of the show, host Stephen Dubner asked the researchers (just G&S) if they thought similar results would hold true for other products - for example, if they thought that a university professor would use her educational expertise to send her child to a fairly priced second-tier university instead of an overpriced Ivy League school. G&S responded that they suspected that it would be quite the opposite - the university professor would be even more keen on sending her daughter to a top-rated university, regardless of price.

There's no doubt that we can learn a lot from how people act, rather than what they recommend. Gerd Gigerenzer says in "Risk Savvy" that one should never ask a doctor what he would recommend. Instead, one should ask the doctor, "What would you do for your mother?" Because I'm so very predictable, you might already have sniffed out where I'm heading with this. Naturally, I was listening to the podcast and wondering if the same result held true for investment professionals. I was intrigued by the analogy Dubner brought up at the end. Thinking about it a little more closely, I see a slight difference in the scenarios. Pharmacists are informed consumers and distributors, yet are not themselves producers of the remedies, and can therefore speak objectively. University professors and (some) investment professionals are more like producers. They are therefore either believers in the product they dispense, or have a cynical incentive to defend their product (reminiscent perhaps of Upton Sinclair's comment that it is difficult to get a man to understand something when his salary depends on his not understanding it).

Still, the question should be asked: are those involved in the active management of investments more or less likely to themselves invest in active strategies? I don't have the data, and a quick Internet search didn't turn up anything fruitful. You often hear hedge fund managers, for example, boast of "eating their own cooking", i.e. investing in their own funds, so I assume that this is common practice for many. But you hear some disquieting things as well. Blackstone's President Tony James recently commented on the hedge fund industry at an event, saying "A lot of people think about hedge funds as a way to get higher returns. Hedge funds are a way to play the stock market with somewhat lower volatility and somewhat lower returns. You don't expect hedge funds to get shoot-the-lights out returns. You save that for private equity and real estate." I found those to be extremely damning remarks from someone whose firm runs Blackstone Alternative Asset Management, which claims to be "the world's largest discretionary allocator to hedge funds, with $61 billion in assets under management." If I were paying a 10-20% performance fee, I would certainly be demanding something more than "somewhat lower volatility and somewhat lower returns" than the stock market. This would be doubly true if I were paying a second layer of fees to an allocator. To most of these intermediaries, I have no more to say than "See ya later, allocator."

The question of hedge fund returns is particular interesting right now. The debate over their value is reaching a crescendo with the news that California's pension fund, CalPERS, is exiting its hedge fund investments due to insufficient returns (post-expenses) and excessive complexity. Responses range from "If CalPERS thinks hedge funds are too complex, then who should invest in them?" to those saying "CalPERS simply didn't do a good enough job in its hedge fund portfolio."

Despite engaging in active asset allocation and security selection, I must confess my low regard for most active management. There are some truly spectacular investors out there who combine keen analysis with strong risk management and a contrarian bent. These people are few and far between, and chances are that if you've heard of them, it's too late. The average investor, I'm sorry to say, is best served by focusing on passive funds. Very often, active strategies are more headache than they're worth - so perhaps headache remedies and investment funds are not so different after all.