Debunking Conventional Investment Wisdom (Part II)

Apr 17 2017 | 5:56pm ET

Editor’s note: The alternative investment industry is currently replete with buzzwords around data, fee levels and operational due diligence, and significant hype exists around these three important but often-misunderstood concepts. In part II of his “Debunking Conventional Investment Wisdom” guest article series, PivotalPath managing principal Jonathan Caplis looks at how investors should approach each of these factors.

Debunking Conventional Investment Wisdom (Part II)
By Jonathan Caplis

The buzzwords surrounding investment decisions involve data, hedge fund fees and due diligence. Below we deconstruct the hype around these important, but commonly misunderstood concepts. 


Misunderstood Concept #1: Data can only improve my decision process and lead to better outcomes.  

Due to biases in our understanding of how to interpret statistics, data-driven decisions often result in high conviction, yet poor decisions that do not improve outcomes.     

Note a famous quiz originally conducted by Casscells, Schoenberger, and Grayboys (1978) described here for acute biases in the medical profession, translated here to a financial context.  

Say you came up with a great process or model that has a 95% accuracy rate of identifying managers with real "skill" leading to future outperformance. Let's also assume that in the population of active managers, only 1/100 are actually "skilled".  While you may only have a 5% chance of selecting a dud, when you correctly consider the conditional probability that the manager is actually skilled, the probability rises to above 83%.   

In this example, even with access to an incredible manager selection process, many investors would make a decision under the assumption the odds are dramatically in their favor. However, if they correctly calculated the probability, they would know their actual chances of success are only 1 in 6.  

Through this analysis, we observe how vastly different our conclusions can be when we misinterpret a basic statistic within an intuitive process. Imagine how easily these biases negatively influence more complicated statistical techniques, where additional degrees of freedom within a model, limit the interpretability of the output forcing one to make decisions solely based on the data. 

For data-driven decisions to be effective, not only must we possess a strong understanding of the underlying data (ensure the quality of our inputs), but we must have the statistical knowhow to correctly interpret the output within the context of a model’s ability (understand the strengths and limitations of our model).     

In the language of information science, there is a well-known hierarchy beginning with data, followed by information and finally knowledge.  To improve decision making, data-driven decisions can be quite dangerous unless they are also knowledge-driven.    

Misunderstood Concept #2: The hedge fund industry is ailing due to high fees    

Have you ever considered that people invest in hedge funds not in spite of, but specifically because of, the high fees?  Well, maybe not exactly.   

With all the negative publicity surrounding poor performance, unjustified fees, and influential pensions announcing they are getting rid of hedge funds, one would expect a significant decrease in total assets.  In fact, total hedge fund assets hit a new all-time high in Q1 of 2017 according to HFR.  Additionally, a 2017 Credit Suisse Investor Survey states that fees only factored in 18% of redemption decisions.   

Consumer behavior studies show, the price-quality heuristic has been demonstrated time and again in luxury goods, like wine.  Academic journals report people judge higher priced items to have higher quality than lower priced things.  

Building upon those findings, however, academics argue that after purchase, when quality falls short of expectations, the relationship between price and quality reverses and becomes negatively correlated.  From the 1990s until the financial crisis, the hedge fund industry performed quite well against its traditional benchmarks.  However, whether expectations for hedge funds are fair or not, there is little question that expectations generally have not been met since 2008.  So what is happening to fees while assets hit new highs and headline or stated fees haven’t moved?

While many hedge funds publicly stuck to their fees, hedge funds have quietly become more willing to negotiate bilaterally.  As the 2017 Credit Suisse Investor Survey found, 61% of investors said that they have preferred hurdle rates, while 57% have renegotiated management fees and 40% have renegotiated performance fees in the last 12 months.  

The pendulum has swung more forcefully in investors’ favor regarding new launches.  Accordingly, 75% of investors in start-up funds conveyed they received a discount via a founders share class in 2016.  Investors in the survey also believe fees will continue to trend lower in 2017.  

So it turns out that consumer behavior, whether considering a fine wine or a hedge fund, is not as perplexing as it might seem.  At some point, quality must meet expectations or prices will be pushed lower.  


Misunderstood Concept #3: Operational Due Diligence is completely independent from Investment Due Diligence:

Imagine a world where you flipped the order of your due diligence process and conducted operational due diligence prior to investment due diligence.   Would you end up with the exact same portfolio or even a similar one?

How often have you gotten comfortable with the investment side of a fund, only to find out during operational due diligence the following:

  • The fund doesn’t require dual signatories for movement of cash 
  • The authorized signatories are related to each other 
  • Employees have both trading authority and reconciliation responsibility 
  • The fund does not have a pre-trade allocation process

Do people acknowledge this is what they are doing? Do you find yourselves asking, “had we only realized this 9 months ago, we wouldn’t go down this path, let alone put ourselves in a position where we are forced to rationalize an uncomfortable decision?”   

If operational due diligence were a truly independent process, your portfolio would be identical regardless of the order of operations.  A deal breaker, no matter what stage of the due diligence process you identify it, should be a deal breaker.  

Ultimately, operational due diligence and investment due diligence should not be completely disconnected as they are integrally related. If a fund takes shortcuts, these shortcuts manifest themselves throughout operational and investment procedures. Conversely, a buttoned-up process firm wide should provide greater comfort for allocators. 

PivotalPath has a “Business Considerations” segment inside its investment due diligence assessments. It asks basic questions where the answers could play a decisive role on the final decision.  While operational due diligence has always followed investment due diligence, this may not always be efficient or correct.  Prior to the financial crisis, operational due diligence was often just an afterthought; it is perhaps no wonder It was saved for last. 

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