Groupthink

1 Groupthink: How investors are driven to mediocrity

F
ollowing the “lost decade” in the US financial markets, we felt that
it was appropriate to offer some perspective and a little history
lesson on modern investing as we know it. Many investors are
sitting on large amounts of cash, scared out of the markets by increased Jay Rogers, Founder of Alpha
volatility. The average person is dumbfounded by the information Strategies Investment Consultants, is an
investment management professional
overload of conflicting economic and financial reports on broadcast with over 15 years working in the financial
TV, MSNBC, the Wall Street Journal, financial magazines, the internet, services industry. His began his career on
the sell side with such firms as Morgan
etc. As investment management professionals for nearly 20 years, even Stanley, Wells Fargo and Bear Stearns.
we are confused by the proliferation of investment options available. It He later worked as Chief Investment
seems like each week a new ETF launches as the new “flavor of the Officer for a family office and made his
transition to the buy side with a startup
month”. long only equity manager. For several
years he also worked for an independent
What this paper will try to accomplish is to provide some background third party marketing firm raising money
in both traditional and alternative asset
on the industry and how we got to where we are today. We are not
classes. Alpha Strategies was created in
selling any product or advocating on behalf of any single manager. Our 2009 to provide boutique and emerging
goal is to provide information as to how the system works so that the managers with a voice in the marketplace
without the costs associated with a full
reader can better make informed decisions regarding their financial time sales and marketing professional. It
future. We are all in this market together and the more financially has since grown into a diversified
financial services company with
stable we are as a whole, the less the government will have to play specialties in investment consulting,
“Robin Hood” and take from those who were better prepared to pay for management and marketing.
those who were not.
Thomas J. Barrett, CFA, CPA,
The passage of ERISA (Employee Retirement Income Security Act) in CFP, is an experienced and
knowledgeable investment management
1974 created tremendous opportunities for those in the financial field professional with a background in both
to provide advice and guidance to corporate pension plans which were securities and accounting. He graduated
concerned about compliance with the newly enacted regulations. In from the University of Virginia with a BS
in Accounting and his early career was in
the mid 1970’s, the financial services industry as we know it today was a the area of public accounting where
completely different landscape; retail involvement in the markets was progressed from auditor to CFO of a real
estate investment firm. He transitioned
enjoyed only by a privileged few and the markets were a few years into into the investment industry when he
a decade long flat line in performance. The nifty fifty stocks of the era joined Payden & Rygel as Controller and
were losing their luster and corporations began to worry about the CFO of their Mutual Funds. He was CIO
of a single family office and then
future obligations of their pension plans. A handful of entrepreneurial CIO/CFO of a multi-client family office
people left Wall Street and decided that providing advice and guidance before becoming a portfolio manager at
UBS. He is now CIO of Alpha Strategies.
was a better use of their time than peddling stocks and bonds to
investors. Alpha Strategies provides specialized
investment consulting services to wealthy
Behold the dawn of the consulting era. The first few investment private investors, family offices and their
consulting firms were set up in major cities around the country and related foundations, advising them on
were breeding grounds for many talented individuals who would later asset allocation, manager selection and
due diligence. We utilize a post modern
break away and start their own firms. If you look at the modern
portfolio theory approach using both
investment consultant landscape and classify them into tiers by AUM traditional and alternative asset classes.
(assets under management) you will see a pattern exists. Where the
first movers (Tier 1) began you see a number of Tier 2 firms

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surrounding them and then a few Tier 3 firms mixed in as well. When you look at the backgrounds and
resumes of the Tier 2 and Tier 3, firms you will generally be able to trace their lineage directly back to a
Tier 1 firm. While these observations are not important for purposes of this paper I point them out so
that you begin to see the genesis of their thought process and how the groupthink that permeates the
industry has evolved.

As the financial services industry has evolved, we have seen the proliferation of registered investments
advisory (RIA) firms (aka money managers) who have developed unique and proprietary methodologies
for investing in certain asset classes. Although the term RIA is broad and far reaching, for our purposes
we will be referring to specialty asset managers (Growth, Value, Large Cap, Small Cap, etc.). I believe the
latest data shows there are close to 10,000 RIA firms in the United States. As the industry has grown so
have the tools available for those managing investor assets in broadly diversified asset classes. Databases
such as eVestment Alliance, PSN/Informa, Morningstar, Zephyr, Pertrac and others have provided
analysts with screening and database tools with hundreds of data points available to screen for managers
based upon very specific criteria. (Alpha, Beta, Information Ratio, Absolute Returns, Risk-Adjusted
Returns, Sharpe Ratios, Up-Down Capture, Standard Deviation, etc.)

Logically, one would think the most important criteria potential investors would be looking for would be
performance, more specifically outperformance above a particular peer group or benchmark.
Unfortunately, that is not the case. The favorite disclosure in the industry is “Past performance is no
guarantee of future returns”. You will see this on every fund managers advertisement or presentation. In
reality, what other measure do we really have besides their track record? Nobody can predict the future,
but your previous decision making should be somewhat indicative of how you will act in the future. Look
at the sports lines in Las Vegas and the odds for any professional sports game. Certainly the win/loss
records of the competing teams have significant impact on the odds.

The explosion in the popularity of investment consultants has been the desire for certain plan sponsors to
shift the liability of decision making to an outside entity. As investment consultants have a fiduciary duty
to act in the best interest of their plan sponsor clients, they accept the liability for the decisions rendered
and the subsequent results. The effect of those decisions has been a huge windfall for institutional
consulting firms working with public plans, corporate plans, Taft-Hartley plans, foundations and
endowments. For the past 30 years the influence of these consulting firms have grown and made a few
very wealthy. Perhaps the most well-known was the first US ‘space tourist’ who paid $20 million for a 7
day trip outside the earth’s atmosphere in April of 2001.

The consulting firms’ dominance over these relationships had held up remarkably well in most cases but
has seen the greatest defections in the large endowment space. Institutions of higher learning are what
we consider to be innovation incubators. Put a bunch of really smart people together in a collegial
atmosphere and tremendous advances are made in the fields of medicine, technology, and even financial
engineering. Harvard, Yale and other universities have created investment offices which have been
pioneers in what has now become known as the “endowment model.” Universities have the luxury of a
long term time horizon and have structured investment portfolios using lots of what we now lump
together into the term alternative investments. Simply put, alternatives refer to asset classes and



investment instruments that are alternative to traditional stocks, bonds and cash. These include widely
accepted asset classes such as real estate, hedge funds, private equity and venture capital as well as exotic
instruments such as credit default swaps, merger arbitrage strategies and currency plays between
sovereign currencies. Endowments started using managed futures as a non-correlated asset class back in
the 1970’s which enabled them to avoid some of the gyrations in the stock markets while producing
steadier overall performance than could have been achieved without their involvement. Managed futures
still have not seen absolute acceptance for their strategies across other plan sponsors as they are still seen
as exotic strategies by some.

Traditional finance, as we view it today and is consistently taught in business schools, is referred to as
Modern Portfolio Theory (MPT) which was first introduced in 1952 by Harry Markowitz and provided a
theory about maximizing portfolio returns per a given amount of risk by carefully choosing the amounts
of various asset classes. MPT is a mathematical formulation of the concept of diversification in investing,
with the aim of selecting a collection of investment assets that has collectively lower risk than any
individual asset. Most commonly this is shown with the efficient frontier hyperbola (Figure 1) indicating
that a portfolio laying on the efficient frontier represents the combination offering the best possible
expected return for given risk level.

Over time, this theory has held up fairly well but has faced challenges because the assumptions used do
not mirror the real-life volatility of the markets, and cannot account for irrational investor behavior or
what is referred to as “Black Swan” events which seem to be happening with increased frequency. The
year 2008 was a prime example of how several historically uncorrelated asset classes all reacted to events
in the market and moved in the same direction. Buy and hold investors took a big financial hit that year
and several major Wall Street players saw their demise at the hands of bad decision making and the
presumption that their size and pedigree made them too big to fail. Many institutional investors who
had assets placed with Bear Stearns and Lehman Brothers lost big thinking that because of their size they
were safe investments. These events served as a wakeup call to many who previously thought smaller
investment managers were risky based on their size. In reality the larger firms were more leveraged and
were so large that they disconnected themselves from reality.



Defining Risk
Consultants and pension investment boards face significant career risk by deviating from the herd and
investing with smaller boutique managers. It is usually safer for an administrator to hire a large “industry-
known” manager and be conventionally wrong, than hire a smaller “less-known” manager and be
unconventionally right. Consequently, the amount of money going into large hedge funds from
institutions is enormous. Even with moderate returns, established hedge funds can continue to grow
based on the management fees generated by the 2/20 (2% management fee + 20% performance fee)
compensation structures of most funds.

As institutional hedge fund allocations have increased, only the large funds have had the capacity to
handle significant allocations. The inability of emerging managers to efficiently absorb hundreds of
millions in new assets has kept some institutions from making allocations. The screening out of
emerging managers has eliminated the 40% of hedge funds with track records of less than 3 years. In
addition, consultants prefer to not “own” more than 10% of any one single manager. This eliminates
more than half the field of emerging managers that may have survived the cut based upon length of track
record. For example, a typical large consultant will allocate approximately $50 million to each of their
approved managers. For any money manager that currently has less than $500 million in AUM, the
consultant will not even consider them for an allocation. Since most emerging managers in the Small
Cap arena tend to be significantly less than $500 million in AUM, this just about eliminates the
opportunity for consultants to consider any Small Cap emerging managers for their client portfolio.
According to Tina Byles Williams, author of “Survival of the Nimble,” a research study on emerging
managers, they tend to outperform larger, established managers by nearly 3% annualized in Small Cap
Growth and over 2% annualized in Small Cap Value over a 5 year period. In addition, her study shows
that these emerging managers are producing better returns without taking on additional risk. What this
tells us is that larger consultants are immediately underperforming (compared to the opportunity set) by
screening out these emerging managers that are producing better risk-adjusted returns.6

Endowments, foundations and family offices generally search for risk adjusted outperformance. But their
CIO’s can still be reluctant to invest with emerging managers. As one family office stated, “We want to
put money to work with smaller firms; but we look for EVERY reason possible to AVOID putting money
into them”. Reluctant CIO’s and consultants ultimately end up waiting to invest in new managers until
the drivers of outperformance (youth and size) disappear. They also assume that other institutional
investors have done the necessary homework on the large funds. Investors in general equate size with
safety, often with disastrous results.

To name a few - Amaranth, Bear Stearns, Long-Term Capital Management, Madoff, Pequot, Galleon
Group and most recently, MF Global were all very large and respected names on Wall Street. These
hedge funds were well over $5 billion, yet they managed to implode in dramatic fashion. “Name”
managers have the tendency to become complacent which results in the erosion of alpha; the funds may
be trading on old paradigms, or in crowded strategies. As hedge funds become larger, their correlations
to other funds and to the markets go much higher, so diversification and non-correlation benefits are lost
by investing in the largest funds.



When markets enter a downdraft, large firms may have difficulty getting out of their own way, due to the
relative size of their position as compared to the markets they are invested in. Smaller, more
entrepreneurial firms benefit at such times due to management focus, rapid decision making processes
and fewer liquidity constraints. A large firm can quickly morph into an organization which lacks that
entrepreneurial edge. Larger funds, by definition, cannot have 100 best ideas. As a result, they end up
with diluted alpha. Smaller funds can still buy stocks from undiscovered places. At some asset size, a
manager is more comfortable taking the annual management fee than worrying about the performance
fee.

Results suggest that while selecting a smaller firm cannot guarantee higher performance, clients
searching for superior performance potential and defensive characteristics are more likely to find them in
this category. This result fits the intuition that as firms grow, they become more interested in growth
than performance, and the distribution of their returns tends to converge toward the median. The risk-
return profile of a fund can start to change as the fund grows and the manager lowers the risk and
volatility to attract institutional investors such as pension funds. Ultimately, this paradox leads the
investor make a decision – invest with an emerging manager with strong incentives for risk-adjusted
returns but less infrastructure and cachet or go with the big name firm with the glossy marketing
materials, large organizational infrastructure and typically more benchmark like returns.

The premise behind setting up a new hedge fund is, hopefully, that there exists a genuine new “edge” in
their strategies, and that their approach will be better than the established competitors.4 Larger funds
often have little choice but to dilute their best trading ideas. Small managers have greater freedom to
invest in less scalable opportunities. Emerging fund managers typically have leaner, more nimble
investment teams. This explains the previous point for a quicker decision-making process in times of
market distress and the need for decisive action. As a result, they can take advantage of market changes
relatively quickly. The first-mover managers that address new market anomalies are generally rewarded
as the dominant players and it can take a considerable amount of time before such inefficiencies
disappear.

In six studies of emerging managers, Northern Trust found that the smallest firms, accounting for only 1%
of institutional market share, enjoyed a consistent advantage over industry leaders. Medium - small
managers gained 6.7% per year for the 5 years ending June, 2010, outperforming the median large firm by
72 basis points per year.1 Small firms also tended to reduce risk when it counted – in bear markets.2

There are various research studies indicating that emerging hedge funds tend to outperform the
established funds and generate higher risk-adjusted returns. In a PerTrac study, the youngest decile
funds beat the oldest decile funds by 970 basis points per annum. They concluded that younger funds
outperformed the larger funds, and with lower risk. The youngest funds had: a) the highest absolute
returns; b) the best risk-adjusted returns; and c) performed better on the downside, losing less than the
established funds.3

1996- 2009 Small Funds Large Funds Young Funds Tenured Funds
Compound ROR 13.52% 9.81% 16.02% 10.78%
Standard Deviation 6.93% 5.94% 6.35% 6.72%
Sharpe Ratio 1.17 0.79 1.62 0.84



Across the investment styles and periods studied, Pension Consulting Alliance (PCA) found that the
distributions of emerging managers’ returns were more often normally distributed than their mainline
counterparts. The skewness (distribution tilt) and kurtosis (degree of outliers) of the emerging managers’
distributions occurred less frequently than with the mainline managers. There was actually more
“surprise risk” associated with mainline managers. From a risk standpoint, its mainstream thinking for
consultants to allocate dollars to larger managers in order to create more predictability in their capital
market assumption modeling. The empirical evidence however, suggests the opposite.

Rajesh Aggarwal (University of Minnesota) and Philippe Jorion (UCI/Paul Merage School of Business)
studied emerging funds and found they tend to add value in the early years. Thereafter, performance
slowly deteriorates. Each additional year of fund age decreases performance by 42 basis points on
average. The average raw return is 12.16% in the first year, falling to 7.99% in the second year. During the
first two years, average performance is 10.1% (with an alpha of 1.57% per year), versus 9.1% during the
remaining seven years (with an alpha of 0.36% per year during the next five years)5. This difference is
statistically significant.

Aggarwal and Jorion concluded that not only does the average emerging fund perform well for the first
few years, but the specific emerging funds that perform well in the first few years seem to continue to do
so. Picking a manager by age was more informative than by size. Analysis indicated that the
performance of new hedge funds does deteriorate over time, but there was strong evidence that early
performance was persistence for up to five years for emerging funds.

Early stage hedge fund investment can be significantly more profitable than investing in older established
funds, but it requires significantly more work from the investment and operational due diligence and
manager monitoring process. As such, investors wishing to tap into the higher returns of early stage
hedge fund investment would do well to hire a specialist fund of fund or advisory services.

Investing via a manager of managers, with proven skills in research, operations and portfolio
management addresses these concerns head-on, and has proven highly beneficial for clients. For those
without the time, resources or intellectual capacity, it’s recommended to consider a manager-of-
managers structure to address these concerns. Well-designed multi-manager programs do entail an
additional layer of management fees as compared to direct investment, but they also provide
diversification and allow clients to work around the capacity limitations of individual firms.

In conclusion, consultants and institutional investors should allocate a portion of their portfolios to
emerging money managers to increase their risk-adjusted returns. The smaller asset managers frequently
have stronger performance than larger ones due to the following:

A genuine new “edge” in their strategies;
Greater motivation and less complacency;
Less bureaucracy, with crisper decision making;
Greater flexibility to deal with changing markets;
Better portfolio performance in bear markets.

In the end, investors must determine what the ultimate goal is for their portfolio. We hope this
information has been useful and leads to better decision making for those investors concerned with the
long term viability of our financial system.



1 Can Elephants Dance? Ted Krum, Northern Trust Global Advisors
2 No Contest: Emerging Managers Lap Investment Elephants Ted Krum, Northern Trust Global Advisors
3 An Examination of the Impact of Fund Size and Age on Hedge Fund Performance PerTrac Financial Solutions
4 Early Stage Investing: Why Emerging Hedge Funds Outperform in the Hedge Fund Life Cycle, John E. Dunn III, UBK Alternative
Investments, Geneva and Tushar Patel, HFIM Hedge Funds Investment Management Ltd., London
5 The Performance of Emerging Hedge Funds and Managers, Rajesh Aggarwal (Carlson School of Management, University of Minnesota)
& Philippe Jorion (Paul Merage School of Business, UC Irvine)
6 Survival of the Nimble: April 2011, Tina Byles Williams, FIS Group

Jay Rogers and Thomas Barrett are principals with Alpha Strategies Investment Consulting, an investment
consulting firm advising clients on asset allocation, manager selection and due diligence in both traditional
and alternative asset classes.


Groupthink

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