In a new book, “The Investor’s Paradox,” Brian Portnoy explores the downside of the vast number of choices investors face.
As regular readers of this column know, we’ve often used this space to explore the contours of manager selection, relying not just on research that we’ve conducted but also inferences we’ve been able to make in managing portfolios for clients. Yet, it’s also useful to consider other perspectives, especially from those who boast reams of experience or are simply insightful on manager research. In Brian Portnoy, we get both— a well-schooled industry veteran who brims with enthusiasm for investing and, in particular, the subtleties of manager selection.
Before joining Chicago Equity Partners as head of alternative investments and strategic initiatives, Portnoy did tours as a mutual fund analyst at Morningstar and as a hedge-fund analyst at Mesirow Financial. Portnoy also recently wrote The Investor’s Paradox: The Power of Simplicity in a World of Overwhelming Choice, a book in which he considers the behavioral and cognitive factors that can make investing so difficult and offers his prescription for simplifying the process, with a particular focus on manager selection.
In January, I had a chance to talk with Portnoy about the book and investing in general.
Jeffrey Ptak: Why’d you write The Investor’s Paradox and what do you hope a reader will take away from it?
Brian Portnoy: The book stemmed from a variety of experiences picking both mutual fund and hedge fund managers and overseeing multibillion-dollar portfolios of underlying funds. One thing I saw all the time was the mismatch between what managers could deliver and what investors were expecting. In finance, we pay very little attention to the ability to communicate complex ideas to one another in ways that are understandable and actionable. I see the book as one attempt to close that gap. I’ve also long been struck by the lack of insight into a task as widely executed as manager research. What exists tends to treat managers like stocks, but people aren’t securities.
Ptak: Many of the investors and advisors reading this not only relish choice, they’ve built businesses around it. If I’m an advisor who builds portfolios, what should I do, or at least be aware of, given the number of choices swirling around me?
Portnoy: First, buy the book! Seriously, one important thing I learned early in my career at Morningstar is that funds are usually sold, not bought. If fund investors, including sophisticated ones, think that they aren’t the target of sophisticated marketing and branding campaigns that are savvy about influencing human decision making, they’re being naïve. It’s certainly true that an abundance of choice has many positive benefits. But those benefits are far more obvious than the downsides of too much choice, which can include various forms of stress and regret. To mitigate that, it’s just critical to have your goals clearly articulated. I think many financial advisors do that very well for their clients. Having targets for returns, volatility, liquidity, correlation, and other concerns allows us all to cut through the noise of marketing and get what we need relatively painlessly. While we always want to be open minded to new opportunities, we also want to be wary of what abundant choice begets.
People Choosing People
Ptak: Speaking of which, you spend a fair amount of time in the book examining the contradictory nature of choice—we desire it, yet it can be paralyzing and elicit feelings of regret—and how to adapt to it as investors. Explain how to connect that to manager research.
Portnoy: I see investing as a specific domain of the much larger field of understanding how humans make decisions. It’s hard to identify a part of the investment process that is not informed, often deeply, by theories of choice, behavioral psychology and economics, cognitive science, and so forth. This applies to decisions made both individually as well as socially. Don’t forget that unlike the world of stock-picking, manager selection involves people choosing other people. The potential pitfalls in that dynamic are both fascinating and daunting. In the book, I highlight what I see as some of our major hurdles such as overconfidence, pattern seeking, loss aversion, and mismanaging information.
Ptak: Given that manager research isn’t a piece of cake, what would you say to those out there who’d ask “Why bother?” and invest in passive vehicles?
Portnoy: Setting up passive as a non-choice is misleading. I have an entire chapter in the book that presents a unique “risk prism” through which we can analyze funds of any kind. Through this lens, the active/passive distinction melts away and we can focus on what really drives investment satisfaction.
The prism looks at five variables: directionality, concentration, liquidity, leverage, and complexity. From this view, cheap index funds are not less risky than active funds, nor should investors think it’s necessarily better to “set and forget” passive investments without first fully appreciating their risks along those five dimensions. I think the stark active/passive distinction goes away when we adopt the view of funds sitting along a spectrum of discretion and flexibility.
Ptak: I agree, but could one argue that it’s a logical response to overwhelming choice in that it reflects investors’ belief that the various options are kind of fungible— beta here, beta there, etc.—and so they reject it as a false choice and go with an index fund?
Portnoy: I don’t disagree with your argument that certain passive choices appear to be simple—if it’s clear that consistently picking outperformers is not possible, why not just buy the “market”? However, passive investments are constructed products, so what’s actually in them, how that could change, and what to expect are not immediately clear. I don’t think many casual buyers of the Vanguard 500 Index VFINX in the late-1990s knew they had a very outsized bet on expensive technology stocks. In addition, there are so many “markets” one can buy through exchange-traded funds that the premise of simplicity with going passive begins to evaporate. I’d also note that even broad markets can go sideways or even down for long stretches of time, and during those times, certain actively managed funds can do quite well. A number of alternative strategies and some traditional actively managed fixed-income strategies did well in the 2000s when equity markets had their “lost decade.”
Ptak: In the book, you offer a construct for better decision-making, arguing that flexible decision-makers in feedback-rich environments are likelier to succeed than dogmatic types who receive less-frequent feedback. So bring that home for investors—how can they detect the qualities of an adaptable thinker, especially when they might lack the access needed to draw such nuanced conclusions?
Portnoy: The best academic research on expertise shows conclusively that experts are bad at predicting the future. But to the extent that some are better than others, it’s still worth trying to figure out why. In brief, the managers I’ve been most impressed by over the past 14 years have been humble and adaptable. They admit mistakes, learn from them, and accept that change is a constant. While few of us are psychologists and none of us are putting our portfolio managers on the couch, we can still concretely observe how much discretion a portfolio manager has in his or her investment program. That’s knowable. When a portfolio manager does not have much flexibility, then you’ll more or less get the underlying beta profile of the market he or she is investing in. There might be some alpha, but the real story there is beta. On the other hand, for funds with broad discretion, it’s very important to understand what levers they can and will pull in order to meet their performance and risk exposure targets. This is a harder task and there’s no getting around it. This is one reason to not invest in more complex strategies—it’s a ton of work without always the commensurate payoff.
Ptak: What’s the right measuring stick for the sort of flexible portfolio managers you prefer?
Portnoy: A good balance between upside capture and downside protection relative to the volatility of the relevant market. In the world of alternative investments, the term “absolute return” is a misnomer in that it might lead some to think that funds with that label won’t or can’t lose money. That’s hogwash. Any fund that takes market risk can and will lose money from time to time. Again, what to expect from a manager is a function of the dialogue between manager and investor. While the term customized benchmark sounds like an oxymoron, it’s the practical reality of gauging nontraditional managers. One reasonable measuring stick for many managers is whether they can generate a certain annualized return over the risk-free rate during the course of a multiyear market cycle. To expect, for example, 10% per year, every year, is wholly unreasonable.
Can’t Ignore Alternatives
Ptak: The book deals heavily with alternatives, which aren’t going to be terra firma for all, or even many, investors. Why the emphasis on alts?
Portnoy: A little bit of history. The Morningstar style box was invented in the early-1990s, corresponding to advances in economic research distinguishing along market-cap and valuation dimensions. Through a confluence of academic theory, product development, and a remarkable multiyear rally in stocks and bonds, the style-box mentality dominated the industry for at least 15 years. Enter the 2008 crisis and what PIMCO has famously called the “new normal,” a time of uncertain and muted returns from traditional investments. Fixed income feels dangerous in a zero-rate environment, and equities feel stretched, so investors are seeking a third way, an alternative. Institutions started the trend a few years back, which is why there is now about $2.5 trillion invested in hedge fund strategies. Meanwhile, mutual fund shops want in on the action and are launching new products at a rapid pace. None of these developments map onto the style box, so putting extra emphasis on these complex, less-well-understood strategies was imperative.
I’ll add one important point: I don’t consider myself a general advocate for alternative investments. In many instances, hedge funds make no sense for the task at hand. It totally depends on portfolio and market circumstances. But my jumping-off point is that an already broad choice set is now even bigger, and we can’t just ignore this quickly changing landscape. There’s too much at stake.
Ptak: How is choosing an alternative manager different from choosing a traditional one? How should I alter my approach?
Portnoy: It’s not different. It’s the same. You shouldn’t alter your approach. I immediately grant that this is controversial and strikes some as flat wrong. My reasoning, however, stems from having spent years on both sides of the industry and seeing far more similarities than differences. I think the key issue here is understanding the discretion a manager has across the various dimensions of his or her investment program. For those tightly benchmarked to, say, the Russell 1000 Growth Index, they are not going to have much wiggle room. By contrast, a fund with a mandate to own all major asset classes globally, both long and short, and employ leverage and derivatives, has extraordinary leeway. From a due-diligence point of view, this is a much tougher nut to crack. But the task is the same at either end of the spectrum and points in between: setting and managing expectations for what a manager will do across market cycles.
Ptak: In the book, you spend little time discussing past performance or expenses. If I’m picking active funds, to what extent should I be factoring in past performance or sweating fees?
Portnoy: There’s too much ink spilt on both topics. Of course, you want low fees. With two funds that have identical investment programs, why wouldn’t you choose the cheaper one? But the aim to provide higher risk-adjusted returns is a tougher task and demands a premium. As does access to more esoteric asset classes. What matters is net-of-fee performance. Would I spend 400 basis points per year in 2000–2002 for a fund that gained 10% net of fees versus a 10-basis-point index fund that dropped 50% in those years? You bet. Performance comes and goes. No one—I mean, no one—knows what the future holds. At the same time, performance—not just returns, but volatility and correlation—can provide great insights on many different questions.
Ptak: Active versus passive is usually framed as an either/or choice. But do you think there are insights manager-pickers can glean from efficient markets theory?
Portnoy: I don’t accept the either/or distinction. I’d encourage investors to think about a spectrum of discretion and breadth built into a fund. Sure, there are S&P 500 Index funds and wildly complicated, go-anywhere hedge fund strategies, but what sits in between is a remarkably broad range of choices. Learning how to figure out what those are should be the task relished by the aspiring fund-picker. To say that many markets are reasonably efficient most of the time, even if true, isn’t a particularly interesting claim. From a manager selection point of view, there’s still opportunity to find those with a sound process that give stable exposure to desired risks. Delivering consistency of process and risk exposures is a highly underappreciated form of skill. Even if one’s perspective is that they want to own a basket of different market betas with a smart asset allocation engine on top, there are still so many questions to answer and human biases to resist.