Matthew “Eddy” Edwards is, in his own words, “a former allocator, 2x emerging manager, news junkie, and Twitter doomscroller”, and Rusty and I are delighted to post his thoughtful note here on Epsilon Theory! You can reach Eddy at [email protected] or on Twitter @eddyfication.
As with all of our guest contributors, Eddy’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.
Milton and Rose Friedman wrote The Tyranny of the Status Quo in 1984. The book examines “a political inertia characterized by ‘an iron triangle of beneficiaries, politicians, and bureaucrats’…in which special interests strive to maintain positions of privilege.”
Capital allocators (e.g., funds of funds, endowments, foundations, pensions, family offices) often succumb to a similar obstinacy when making manager selection decisions. Their version of inertia stems from a bureaucratic mix of incentives, process, and decision-making that combine to stifle creativity and limit outcomes.
This is best exemplified by codified rules that allocators often employ when considering investments, resulting in a paint-by-numbers manager selection process that perpetuates legacy thinking.
The restrictive nature of this rules-based approach inhibits the ability of allocators to maximize their individual outcomes and collective value-add. Instead of encouraging open-mindedness, it forces ideas into tidy boxes hemmed in by carefully constructed guardrails, the investment equivalent of bumper bowling.
It is said that there is an art and science to investing. But the rules-based system removes any semblance of the art, favoring instead a perfunctory, tick-the-box approach that distinguishes between the practice of allocating and investing.
The allocator is motivated to maintain the status quo as a matter of self-preservation and advancement. Coloring within the lines of conventional wisdom is standard procedure for those tending their multi-manager gardens.
The investor is guided by a genuine pursuit of truth driven by intellectual curiosity. Their path to discovery is characterized by independent thinking and experimentation in the hunt for optimized outcomes.
Jonathan Chait coined the term “zeroism” in a recent New York Magazine article. It refers to the risk assessment that certain groups have applied to COVID-19: If there is a nonzero risk of infection present with any activity, then that activity should not be pursued. Such response to the potential for micro risk ignores a broader cost/benefit analysis at the macro level.
Per Mr. Chait:
“The pandemic becomes an enemy that must be destroyed at all costs, and any compromise could lead to death and is therefore unacceptable.”
A similar approach to zeroism has been adopted by the vast majority of allocators, limiting their ability to entertain new ideas.
Mr. Chait’s observation can be rewritten for our purposes here:
“The [mistake] becomes an enemy that must be [avoided] at all costs, and any compromise could lead to [loss] and is therefore unacceptable.”
What follows is a selection of rules emerging fund managers commonly encounter, each of which represents a type of thought-terminating cliche. The implementation of these rules varies by allocator, but there is remarkable consistency in their usage amongst a community better known for its uniformity than individuality.
Human beings are creatures of mimicry. We are evolutionarily supercharged to do one thing better than anyone else: learn by watching and copying others. — Alex Danco
We don’t do crypto.
Raising money for a new fund is always a herculean task, and the degree of difficulty is magnified for firms operating in digital assets. With an allocator community whose collective job is to say “NO” 99% of the time in normal course, one can imagine the challenges associated with cracking that affirmative 1%. This is especially the case for ideas that are unfamiliar and require creative thinking to engage.
Despite all the press that crypto has received in recent years, allocators generally remain reluctant to engage with the asset class. According to a survey reportedly conducted of over 1500 institutions during a recent J.P. Morgan macro conference, 89% of such investors had no exposure to crypto and 78% of them had no plans to invest in the future.
That said, 58% of respondents admitted they believe crypto is here to stay. It would be interesting to explore the overlap between those with no current exposure nor any plans in future and those saying crypto isn’t going anywhere. “Yes, we believe crypto is here to stay, but we have no plans to do anything about it” is an interesting strategy indeed.
There is a concept in psychology called inattentional blindness. According to Wikipedia, it “occurs when an individual fails to perceive an unexpected stimulus in plain sight, purely as a result of a lack of attention rather than any vision defects or deficits.”
This phenomenon was popularized in the above video clip, which asked viewers to watch a bouncing ball being passed among a small group of people wearing alternating white and black t-shirts. Viewers are instructed to count how many times the white shirts pass the ball amongst each other. In the middle of the clip, someone in a gorilla suit nonchalantly makes their way across the screen, stopping halfway to beat their chest while facing the camera.
The catch here is that the gorilla goes largely unnoticed by observers. This is because most of us are too busy diligently counting the number of bounces among white-shirted players to notice the random gorilla inserted into the mix.
In my way of thinking, the white shirts represent established strategies and managers that dominate conventional investment programs. The bouncing ball represents performance that is being closely monitored by the allocator/observer. The black shirts represent competing strategies and managers that are playing the exact same game — with virtually the exact same results — but who exist on the periphery, mostly beyond the allocator/observer’s immediate field of vision. This is what is known as selective attention.
The bigger miss is of course the gorilla, which is representative of crypto in keeping with our allocator theme. So busy focused on the bouncing ball of performance achieved with traditional approaches, the allocator/observer is oblivious to the crypto gorilla.
Once revealed, the gorilla is hard to miss, to the point of being obvious. I expect the same sequence to occur with crypto. Currently a new asset class that requires some combination of open-mindedness and courage to engage, it will eventually graduate to the point of obviousness.
For now, most allocators cannot muster the bravery or curiosity to engage with what I believe is one of the most inefficient asset classes in the world. Even for those who have managed to dip their toes, they’re almost exclusively focused on the white shirts of crypto (directional plays via bitcoin and/or venture capital). Less common is a willingness to expand the surface area of that engagement to fully capitalize on the potential that comes with the birthing of an entirely new asset class.
…every investment is valued by taking a number from today and multiplying it by a story about tomorrow. Sometimes an asset is mostly numbers, sometimes it’s all story. But there’s always a story about future potential involved. And stories aren’t beholden to reason or logic — they’re just whatever people want to believe. — Morgan Housel
We only invest in what we know.
Making informed decisions is a reasonable pursuit. Measures should be taken to ensure that allocators understand the risks associated with their underlying exposures. Legendary investors such as Warren Buffett and the late David Swensen made this idea a pillar of their respective philosophies.
But in order to better understand something, one must be willing to try to understand it. The first step to capitalizing on a new idea is being open to it in the first place. Allocators often refer to their “circle of competence” as being a gating mechanism when it comes to entertaining new ideas. A certain rigidity is implied here, as if those limitations are set in stone. This can result from resource constraints but so too can it derive from an almost proud complacency. I find that allocators often revel in their ignorance on the topic of digital assets, almost wearing their incuriosity as a badge of honor.
Mr. Buffett infamously missed the internet boom because of his disinterest in understanding what those new business models might mean for his old way of thinking. This does not take away from his incredible accomplishments as an investor, but it does speak to the opportunity cost of indifference. Markets are complex, adaptive systems. Managers and strategies evolve accordingly over time. Allocators should too.
Third Point’s Dan Loeb recently tweeted about his own journey down the crypto rabbit hole, noting that doing so is a “real test of being intellectually open to new and controversial ideas.”
…maintaining healthy skepticism while also deepening one’s understanding requires one to engage in what Steve Jobs (and Fitzgerald before him) described as requisite for a superior intellect: “to maintain two opposed ideas in ones mind and retain the ability to function”.
This is a great observation and speaks to the importance of understanding the existence of a maximalist-denialist spectrum. For all the hyperbolic headlines, many of us view crypto as just another asset class to trade, which offers an actionable compromise between skeptics and diehards. One can reject the anti-crypto camp that is the default setting for most while also avoiding dogmatism about the role that digital assets should and could play.
Management guru Roger Martin captured this ethos well in his book, The Opposable Mind:
The ability to face constructively the tension of opposing ideas and, instead of choosing one at the expense of the other, generate a creative resolution of the tension in the form of a new idea that contains elements of the opposing ideas but is superior to each.
Denialism and maximalism share a weakness in that such thinking can blind one to the many possibilities that lie along the spectrum connecting them. Navigating the space between is where the real opportunity lies. Skepticism can persist along the path of tradeable value-add.
There is also an uncomfortable truth worth acknowledging in the context of this excuse: Most allocators are staffed by career allocators. Those charged with choosing which strategies to pursue — and which managers to execute those strategies — often have no direct investment experience of their own. This means there are plenty of things contained within allocator portfolios that — if we’re being honest — are not fully understood.
Surely there are many allocators that have neither strong conviction in — nor understanding of — the Japanese Yen (“JPY”). But they probably care about USD/JPY dynamics when revisiting the performance of their macro manager holdings. The same often applies to the option strategies being employed by volatility arbitrage managers and to the myriad securitized products comprising the portfolios of opportunistic credit managers.
A common source of frustration for managers is being judged by people who lack the requisite experience to do the judging. Imagine a veteran stock-picker having to pitch a young analyst — often the first line of defense for larger allocators — whose experience is limited to collection of a fancy undergraduate degree and landing an allocator gig out of school. They’ve spent their entire young career mostly papering files and ticking boxes yet have convinced themselves that they understand this investment game better than most. Even those allocators who have spent decades in the profession often have no experience in the market itself.
Adding to this assessment is a thread by Adam Wyden of ADW Capital:
There are plenty of thoughtful allocators doing yeoman’s work in earnest attempts to be great at their jobs. But making true understanding of something a prerequisite for allocator engagement would, in practice, turn the infamous endowment model into a much simpler construct. This is not to suggest that knowledge is unnecessary or overrated when it comes to investing. But I suspect allocators are more comfortable investing in things they do not fully understand than they let on.
The fact that you are not sure means that it is possible that there is another way some day. That openness of possibility is an opportunity. Doubt and discussion are essential to progress. — Richard Feynman
We never pay full fees.
Performance among traditional hedge funds has generally disappointed since the Global Financial Crisis (GFC). As full cycle return expectations have declined from 20% to LIBOR+, the standard 2/20 fee structure has come under pressure. When the quality of return deteriorates, fees can be expected to compress, especially premium ones.
Back when hedge funds delivered on their original promise of maximizing absolute and risk-adjusted returns in uncorrelated fashion, the wisdom of paying full fees went largely unchallenged. This is because the net-net result still made sense for the end investor, especially one that could not build an absolute return program on its own.
Things are much different today, with only a small subset of funds able to charge the lofty fees of yesteryear. Even when a fund’s fees have been rationalized lower, many allocators still refuse to pay rack rate as a matter of principle, making the negotiation of fee discounts an industry pastime.
But if the return objectives being pursued harken back to those early hedge fund days, if the nature of the strategy is truly differentiated, and if that exposure is difficult to replicate, then the all-in fees could be justified.
An article in The Economist last year thoughtfully addressed this topic:
…it is quite wrong to insist, as many do, that the only good fee is a low fee. There is a case for paying more for access to a stream of cash flows that is genuinely different from those you already have. The asset manager may not deserve the fee for his efforts. It may just be a pure rent. But sometimes it is best to suck it up. After all, it is returns net of fees that you should care about.
…some alternatives are truly different. If you are up to your teeth in the mature, ripe-for-disruption firms…it might be a sensible hedge to also get exposure to the would-be disrupters…
The fee is the price of entry to a market that is hard for most investors to navigate. [put another way]: “They know how to do it and you don’t.”
There is also the practical issue of sustainability to consider. Emerging managers are — by definition — young and likely to have relatively limited assets under management (AUM). In some cases, these managers may be pursuing strategies that are relatively capacity-constrained (like crypto) and are therefore not the asset-gathering machines allocators fear with traditional fund managers. This means whatever fees can be generated by these fledgling businesses are critical to the enterprise. So the more they are negotiated away, the harder it will be for them to survive long enough to matter.
Price is what you pay. Value is what you get. — Warren Buffett
We prefer fundamental investment strategies.
Allocators convinced themselves somewhere along the way that fundamental analysis was a repeatable skill and thusly lent itself well to manager analysis. The more analytical structure involved in an investment approach, the more likely a process could be built around it. A process that could be consistently implemented, taught, refined…and underwritten. This all in an attempt to make an otherwise complicated system more legible.
Fundamental investment approaches have historically worked well, especially prior to the GFC. But since then some combination of the Fed (e.g., easy money), generational replacement, and technological advancement (e.g., Robinhood) has allowed narratives to prevail over fundamentals (e.g., Tesla). Something is clearly amiss when companies see their stocks rally 200% following bankruptcy announcements.
A recent article in Fortune captured this dynamic well:
This is [Gen Z’s] market. It’s growing horizontally and cannot even contain the amount of capital swirling around in the ether. It’s expanded outward to include blank-check companies, venture-backed startups, tradable bits of computer code, investable software protocols, claims on fractional ownership in everything from comic books to cars and a whole lot more. The everything-goes-up era will end someday, maybe even soon, but the habits, expectations, and ambitions it created won’t go away.
Not surprisingly, some of the best investors of all time have struggled during this period, including the likes of Warren Buffett and Seth Klarman. How many manager letters over the past decade have justified underperformance with a lament about markets not responding to fundamentals? Meantime, memetic investing is minting millionaires overnight. Is it better to shake our collective fist at this or adapt to what may be a paradigm shift of sorts?
It is here that I agree with Paul Graham that “ideology is constraining” and “everyone is too much in the grip of the current paradigm”. The obsession with fundamental-based strategies is an allocator ideology. It represents status quo thinking that has demonstrative downside when pursued in myopic fashion, both in terms of opportunity cost and the consequences of conformity. When all of our managers think the same way, then we should not be surprised when their correlations run to one over time, particularly during periods of stress.
For example, many allocators completely avoided macro and systematic strategies leading up to the GFC, only to add them to their portfolios the following year once they learned — the hard way — the benefit that differentiated sources of risk/return can bring. Further evidence of this reactionary mindset is the fact that many of these same allocators were also quick to add tail risk protection to their portfolios, which was precisely the wrong thing to do given the richness of volatility following a multi-standard deviation event like the GFC.
It would be unreasonable to advocate for complete abandonment of fundamental approaches to investing. But an argument can be made that some combination of market backdrop and diversification benefits may warrant an open-mindedness to different styles and approaches.
The risk of becoming too steeped in any one framework is you start to be “subject” to that framework, you can only look through its lens, not at the lens. I recommend trying to hold a handful of frameworks in your mind simultaneously in order to maintain flexibility. — Graham Duncan
We seek strong alignment of interests.
Allocators place a premium on managers having their own “skin in the game”. This is a standard response on podcasts that explore what allocators look for in prospective managers. Alignment typically takes two forms: fees and principal investment. The latter will be our focus.
The logic here is straightforward: Managers should be willing to eat their own cooking. The belief being that such alignment not only demonstrates commitment but also somehow lessens the likelihood that irresponsible things might be done with investor capital.
This is an interesting demand from an allocator community that often has little skin of its own in the game. Foundations, pensions, and endowments have rules that prohibit investment teams investing alongside them. But how many of those teams are formulaically compensated on the basis of performance rather than clipping a salary and being paid a discretionary bonus that is only loosely tied to portfolio outcomes? Not very many. The only real skin in the game these teams typically have is political, which means incentives are structured in such a manner where conviction is mostly measured in terms of career calculus.
All else being equal, fund managers investing in their own funds is a fine — even preferred — practice. But the focus here is overblown as an underwriting consideration.
The reality is that investing on behalf of others makes fund managers more risk averse, especially in a fund’s formative years. The notion that investing alongside their limited partners would cause managers to act more responsibly than they would otherwise is frankly just wrong, not to mention it takes a dim view of human nature.
What is lost on many adhering to these archaic rules is that those seeking to build their own funds have already risked everything simply by putting their names on the door. For many of these managers, starting their own funds is the culmination of their life’s work. Failure won’t necessarily make them forever unemployable, but it will change their career trajectories, not to mention the ego hit that comes with shutting down. Moreover, these people often have significant sums of their own money already tied up in the business since it is typically the founder who capitalizes the whole enterprise.
Think of some of the biggest hedge fund blowups ever — Amaranth, LTCM, Parkcentral, Sowood — and consider whether the principals were among those funds’ largest shareholders. We also have the recent example of Bill Hwang’s Archegos blowup, which — being a single family office — was presumably 100% comprised of his own capital.
Some argue that investors should not have to assume all the performance risk while the manager stands to enrich itself if things go right. But in order for a manager to enrich itself on the back of investor capital, it must accumulate that capital first. Everyone knows that we’re all performance chasers in the end. So in order to attract capital, the fund needs to perform. Incurring a significant drawdown — especially early days — is effectively a death knell for any emerging manager. So here again we see plenty of alignment even in the absence of general partner capital in the fund.
Lastly, there is the question of what constitutes the right amount of liquid net worth a manager should be investing in their fund. For some allocators, the answer is 100%, which is not only irresponsible from an asset allocation standpoint but also magnifies a manager’s pressure to perform.
So sure, having a manager’s capital invested alongside its investors is great. But its benefits come more in the form of psychological comfort through signaling than in practical terms, as the alignment that investors claim to seek is very much already present.
We cannot be greater than x% of a fund’s total assets under management.
In What It Takes, Blackstone’s Stephen Schwarzman shares insights gleaned from his experience building one of the world’s premier alternative investment firms. One story recounts the importance of two people who proved critical to the firm’s early success: Sam Zell, who was among the first visitors to Blackstone’s office; and Garnett Keith, then the vice chairman and Chief Investment Officer of Prudential (at the time the number one financier of leveraged buyouts).
Zell would turn out “to be worth more to Blackstone than all the clients we expected in those early days who never came”, and Prudential would end up becoming Blackstone’s first institutional investor, thanks to a $100 million commitment secured over a tuna sandwich lunch with Mr. Keith (we can only assume he was not beholden to the types of rules discussed here!).
Some of the world’s most successful asset managers had their fortunes turn on the early belief of a select few. Citadel had backers like Glenwood’s Frank Meyer to provide funding and inspiration, and Tom Steyer got Farallon off the ground with the help of a day one investment from Warren Hellman (followed shortly thereafter by the aforementioned Mr. Swensen).
There is a saying that money makes money, and such early support provided the foundation upon which these hedge fund titans were able to build their empires. Being the first money in requires independent thinking, vision, and — perhaps most important — a willingness to be wrong. These brave first movers blaze the trail for the many who follow.
Unfortunately, though, AUM is treated as a risk metric and thusly provides another example of manufactured guardrails. This rule is perhaps the most blatant in its groupthink, as it effectively means an allocator needs to know that other people are doing something before they’d be willing to do it themselves. This has the ring of “Who is your lead?” from the land of venture capital.
It is depressing to consider the amount of capital destruction that has occurred with allocators following the herd. The largest hedge funds in the world have tens of billions under management, not necessarily because they perform for their investors but often because of the lemming-like inertia that develops around allocator flows.
Outside of certain pension fund and asset manager ownership limitations, there are few formal restrictions associated with a single investor constituting a significant percentage of a fund’s AUM. Some allocators claim they would rather avoid wielding such power over a manager, preferring to eschew that existential responsibility. But there is a chicken-and-egg dynamic at play here, as managers would happily allow for that concentration risk since it solves their existential dilemma in the first place.
A strong measure of confidence is willingness to be the first money in. But this requires acting on the basis of belief rather than comfort, which is often lacking in allocator circles. As Mr. Swensen reminds us:
Far from exhibiting the courage required to take contrarian stands, most investors follow the crowd down the path to comfortable mediocrity.
Mr. Schwarzman had a similar observation:
While most investors say they are interested in making money, they are actually interested in psychological comfort. They would rather be part of the herd, even when the herd is losing money, than make the hard decisions that yield the greatest rewards. Doing what everyone else is doing seems like a way to avoid blame.
This reminds me of a viral video featuring a breakout dance session at the Sasquatch Music Festival in 2009. It starts with a single guy blissfully dancing on his own to the song “Unstoppable” by (the excellent) Santigold.
The clip is a brilliant representation of decision-making in the context of allocator herd mentality. “Dancing Guy” is doing precisely what one should do when surrounded by good people and good music. He’s dancing without inhibition and maximizing the quality of his experience.
Onlookers initially suppress their own urges to join in. “Sure, that looks fun, but maybe we’ll look silly?”. An intrepid soul in the form of a green shirt eventually arrives to join the Dancing Guy. The two of them dance together for about a minute, feeding off of each other’s energy while delighting in a shared music festival experience.
Slowly but surely, dozens of festival-goers join in on the dancing fun. Before we know it, more people are dancing than not. One would be hard-pressed to find a better illustration of group dynamics that apply to the allocator mindset. Music festivals are there to be enjoyed, just as risk/return profiles are there to be maximized. All of us builders are the Dancing Guy waiting for our green shirts to arrive.
Requiring a minimum AUM is an implicit admission that an allocator would rather be part of a rumbling herd than ruled by autonomy. They invest on the basis of convention rather than conviction.
The problem with this rule is punctuated by the fact that smaller managers have been shown to consistently outperform their larger counterparts.
If someone I knew to be both a domain expert and a reasonable person proposed an idea that sounded preposterous, I’d be very reluctant to say “That will never work.”…If the person proposing the idea is reasonable, then they know how implausible it sounds. And yet they’re proposing it anyway. That suggests they know something you don’t…Such ideas are not merely unsafe to dismiss, but disproportionately likely to be interesting. — Paul Graham
We require a minimum track record of X years.
A standard disclaimer with marketing decks and performance summaries is that “past performance is not indicative of future results”. This is mandated by regulators to remind investors of something that has proven true over multiple academic studies: track records have little bearing on future outcomes. Prior performance of individual funds is in fact statistically insignificant and carries virtually zero predictive power when it comes to forward-looking returns.
Mr. Swensen openly admitted as much himself:
I think track records are really overrated. Some of Yale’s best investments have been with people that [didn’t] have a track record…it doesn’t mean we don’t like to look at track records. It’s a nice thing to have. But we would miss out on some incredible investment opportunities if we required three years of audited or five years of audited returns before backing somebody.
Yet the vast majority of allocators have minimum track record requirements, with observation periods often ranging from a few quarters to several years.
Referring again to his book, Mr. Schwarzman recalled a frustrating trip that he and his partner, Pete Peterson, took to Atlanta to pitch Delta Airline’s investment fund.
We were trying to get $10 million from these people. They had read the material and invited us down. We were offering the kind of fund they usually invested in. We went through our presentation with all of our usual enthusiasm, emphasizing our expertise, our contacts, and the opportunities we saw in the markets. When we finished, I asked…’Do you find this of interest?’. ‘Oh yes. Quite interesting, but Delta doesn’t invest in first-time funds.’
Why is this the case when experience and data suggest that a fund’s track record has no bearing on its future success? I can venture a guess. It relates to what Richard Zeckhauser refers to as blame aversion. Above all else, allocators are most often focused on career risk, and it shows with rules like this.
Here’s the truth of the matter: Requiring a minimum track record is an implicit admission that an allocator is a performance chaser.
This also speaks to the difficulty of manager assessment. Allocators need to hang their hats on some sort of analysis when choosing which investments to make, and actual performance is the most tangible. But the superficiality of our performance chasing reality gives lie to the robustness of many institutional due diligence frameworks. When performance is 95% of the battle, managers should be forgiven for their collective eye roll when it comes to everything else.
A natural tension has developed between fund managers and allocators. This is partly informed by the significant supply/demand imbalance that puts managers at a statistical disadvantage, with thousands of them competing for only a handful of available seats at each allocator table.
Rejection is simply part of the game. Paraphrasing Steve Jobs, “allocating is saying ‘NO’ to a 1000 things”. But even knowing the long odds, the nature of rejection can be off-putting. Allocators often never respond to outreach attempts, summarily dismiss ideas upon cursory review, or completely disappear following some sort of engagement. Or they talk about setting a high bar for themselves by only investing in managers they deem the very best. The implication here is that you, the rejected manager, lack that potential, which can be a tough pill to swallow. That decision being made a 28-year old with no real world investment experience only harshens the blow.
Another reason for this tension is the philosophical difference in approach between managers and allocators. Allocating has increasingly become an ex-post exercise whereas investing is more often ex-ante. The codified rules highlighted herein suggest a procedural nature to allocator decision-making that extrapolates the past (e.g., track record, AUM, etc.) into the future. This effectively limits the judgment part of the allocator equation, which is a hard square for investors to circle.
Conversely, managers exist to exercise judgment about an uncertain future. A company’s historical performance can be relevant to a fund manager’s analysis, but more important is their expectation about future revenue growth, product development, leadership, regulatory environment, competitive positioning, etc.
Steve Mandel, founder of Lone Pine Capital and one of the most successful hedge fund managers of all time, recently appeared on Invest Like the Best with Patrick O’Shaughnessy. When asked what makes for a good analyst, Mr. Mandel answered with the following:
People can be unbelievably smart, but if they’re very linear thinkers, it will never work as an analyst. We are always dealing in shades of gray, probabilities. If someone has to know THE answer…there is never THE answer in our world.
There is a linearity to allocator thinking that managers struggle to understand. Managers live nonlinear lives and assume the people they pitch will do the same. They expect allocators to exercise judgment about a manager’s ability to perform in an uncertain future when instead they use the rear-view mirror as a stand-in for such judgment. This is a clash between mentalities — employee versus entrepreneur — and motivations — careerism versus profit.
The poet John Keats referred to rejection of the quest for definitive answers as negative capability: “the willingness to embrace uncertainty, live with mystery, and make peace with ambiguity.”
Allocators mostly demonstrate positive capability, acting as processing agents that focus exclusively on the past with little thought given to the possible. The whole point of the allocator game is to win by not losing, to limit any potential for blame by doing what‘s always been done. Nobody gets fired for being average, making mediocrity a powerful motivator.
Plenty of allocator professionals would love to flex their creative muscles and think more like investors. But until our ossified decision-making apparatus incentivizes such thinking, the zeroist status quo will persist.
 A process orientation has become part of allocator canon. “Process over outcomes” is a common refrain, which is a nice mantra that makes no practical sense. The reality is that most manager processes can be described as fluid at best. They often involve disjointed information gathering (mosaic theory!), undifferentiated analysis, and a decision-making exercise that tends to skew towards unstructured (i.e., a single decision-maker exercising unique judgment). This is not to suggest that some semblance of process is nonexistent or that process is never critically important for some. In fact, for systematic strategies, process is entirely the point, which is why these tend to be “black box” in nature since the more structured your process, the more replicable it is. For most non-systematic strategies, I contend that process is often less important, organized and complex than most make it out to be. What allocators are ultimately betting on with any investment is the ability of a manager to take and manage risk, much of which comes down to the art rather than science of it all. When asked about their investment process, investors like Stan Druckenmiller and Warren Buffett spend more time discussing their philosophical approach rather than a process per se. And if pressed for details, any attempt to arrive at an answer will involve efforts to simplify whatever a process might look like for them. In many cases, the most time managers allocate to thinking about process is when developing the obligatory slide for it in their presentation decks. Process is often just window-dressing and doesn’t matter much to anyone so long as the results are good enough. Is there an allocator in the world that has justified making or keeping an investment in a manager with a mediocre track record but great process? “Sure, manager XYZ has relatively poor returns but they have a great process”, said no allocator ever. A more honest mantra among allocators would be “outcomes over process…all day every day”.
 A stubborn myth has been perpetuated that failed managers can easily run away from poor track records by shutting down and starting anew with a clean slate. The reality is that this rarely happens. In fact, one would be hard-pressed to find a single hedge fund operating successfully today that attempted such a renaissance and lived to tell the tale.