The Calpers' Hedge Fund Fiasco: The Solution They Missed

I guess you noticed that Calpers has just ditched investing in hedge funds. The official line was that it was too complicated. The truth of the matter was that it didn’t work. .   That tells us a lot about hedge funds and investing generally and you know I am going to draw my own conclusions from that.

First it’s been clear for a long time that managed investing is generally inferior in terms of performance to just following an index of the S&P. In other words, you are better off throwing a dart than hiring one of the overpriced financial managers in Wall Street. Research over a number of years has demonstrated this conclusively so it’s amazing that the hedge funds continued going for so long. Put it down to investor conservatism, blindness, willful or natural, and the superb sales skills of the hedge funds.

Ok so now its old hat that the hedge funds don’t work. But what about the investment practices of the thousands of pension funds out there? They are their own hedge funds. They manage the funds with their known managers. True, some of them are increasingly starting to use indexing approaches also, but the majority doesn’t. So most pension funds are still using approaches that have proven to be useless in practice in beating the market.

And how about mutual funds? Same story. An increasing number of indexers but still many that follow the traditional way that doesn't work.

So what is that way? Remember Ben Graham and fundamental analysis? Yep, that one. The one that Warren Buffet says he swears by and is still the investment bible of millions of people.

The vast majority of investors in the world use fundamental analysis be they professional, or private. And the vast majority of finance courses at universities also teach fundamental analysis. It’s the closest thing to a bible for the finance crowd. In other words, we can view fundamental analysis as the bible of the finance religion.

But, as we have seen, if you apply it in practice it will do worse than just following the S&P. So what gives? Why are millions of people following a religion which has been shown not to work? And, why do they do it? Is it because there’s nothing better out there?

Until recently there hasn’t been anything better. But with the advent of the disciplines of behavioral finance and behavioral economics a new way forward has opened up. Trouble is the vast majority of universities and finance schools don’t teach it because it’s too new for the academics to have caught on yet. And how you actually apply it in practice, as distinct from the theory, is still a conundrum.

But the general theory is clear. People and managers routinely make decisions on non-rational grounds. They have biases that move them away from doing what traditional economics and finance tells us is rational. So you have to understand the cognitive biases of the managers making decisions about a company to understand what could happen. If you understand the innate financial behaviors of people and managers, then you understand the motive force behind the figures their companies produce. Obvious right?

Well yep. But not so obvious that the hedge funds, Wall Street, universities almost everywhere, investors both private and public have caught on yet. But the answer is there is plain sight; if you want to understand and predict the performance of companies, you have to understand the financial behaviors of the executives and management teams that run them.

If you do that you actually understand the behaviors that are behind the financial results that a company is producing. If you understand these behaviors, warts and all, then you have a fighting chance of understanding and predicting the performance of the company.

That’s in fact what my company has been doing for a long time. We have developed psychometric assessments that do precisely that. But it’s been a bridge too far for a lot of the investing professional and academics. The Calpers move for the first time is a public acknowledgement that fundamental analysis doesn’t work. By extension it’s a call to action to understand that investors have to understand managers’ financial behaviors in order to discover the way forward.

In any case, what else do we have? Technical analysis? Yeah right. Quants from the physical sciences and mathematics? That hasn’t worked either. In fact the professional consensus is moving to the position that the only thing that works is to blindly follow an index of the S&P. If that isn’t a pusillanimous, weak-kneed approach to scholarship, I don’t know what is.

The writing is on the wall. The next step forward to getting performance that beats the S&P is to use behavioral analysis that focuses on the financial behaviors of managers and executives of the companies you want to follow.

Mark my words, this revolution is coming. Let’s hope that investors and hedgies hop onto it before they’ve lost another few trillion dollars of widows’ and orphans’ savings.