The Three Most Common Biases of Hedge Fund Managers
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An upcoming NYSSA forum will be exploring the opportunities, risks, and challenges of investing in emerging hedge fund managers. In the absence of a long track record to review, the field of behavioral finance may offer particularly effective tools, not only for identifying the best emerging talent but also for detecting manager biases that may translate into future blowups.
Cynthia Harrington, a former large-cap value manager who now uses behavioral finance principles to coach hedge fund managers, has observed that their three most common biases are confirmation bias, herding behavior, and overconfidence.
Confirmation bias is the tendency to focus attention solely on new resources and information that support a previous action or belief. Harrington reports that this is a difficult bias for a manager to reflect upon. Even when managers go through the exercise of looking at an opposite case to their ownership position, she notes, they have a tendency to listen to others and read materials that confirm what they already believe. For example, one of her clients recently went through an elaborate exercise of constructing an investment case for closing out a large short position that the manager believed in but that had been going against him. “In our session together we reviewed the report,” says Harrington. “It became clear that he had not built a case that prompted an emotional commitment to the other point of view, thereby leaving intact the previous belief, despite the fact that he had diligently listed all the ‘cold’ facts on the other side.”
An investment committee looking to detect confirmation bias in a fund manager might see it showing up “if he or she is stating that their strategy or execution is the only one in town,” says Harrington. If a potential manager is asked why their strategy might fall apart and if he or she says something like “all the research shows this strategy will continue,” the evaluator should probe more deeply into the manager’s thinking. “That response suggests the manager is either in denial or has not thought through the interactions of their strategy with other market participants and conditions,” Harrington maintains.
Harrington says that herding behavior, unlike confirmation bias, is fairly easy to identify, both for the manager and the evaluator. However, while “most professionals know when they are being caught up in it they nonetheless have a tendency to rationalize it,” she has observed. At the height of the dot-com boom and in the 2006 and 2007 subprime boom period, for example, those most caught in the herd mentality might have been likely to make pronouncements like: “it’s different this time,” or “there are structural changes going on in the market,” or “the new Fed monetary policy is a game changer and this subprime boom may continue,” or “it makes sense for these technology companies to have these valuations because they are the future of the economy.” An evaluator should take note when a manager makes such rationalizing statements.
In the behavioral finance literature, overconfidence is defined not so much as braggadocio or ego-driven behaviors but as “overprecision in the range of expectations for the future,” says Harrington. If a manager’s projections of their future performance or of the economy are too precise, it may suggest the sort of overconfidence that should be cause for an evaluator’s concern.
Overconfidence also shows up in two other manifestations says Harrington: when a manager overestimates his or her own performance in absolute terms and when he or she overestimates it relative to others. “So if for example they say that they are using a cross volatility arbitrage strategy and are the only ones in the market doing so, that should raise a red flag,” Harrington reports. “In the hedge fund business if you are the only one doing it today, there will be 50 people there tomorrow, and a manager who is not acknowledging that is reflecting a naïveté.” Follow-up questions might probe for the manager’s experience with other strategies that became too efficient to create alpha, and what controls the manager has in place to detect such a situation for his or her own fund.
The tendency to exaggerate one’s performance relative to others may be particularly pronounced with emerging managers because their track record is short. Overconfidence may look like a virtue because without it the emerging manager may not be able to make the sale. “But you should listen for an acknowledgement at some point indicating that the manager knows his or her track record is short,” says Harrington. “An evaluator might think in terms of distinguishing between confidence and what is in fact 'ego alpha.'”
Adding a layer of complexity to the subject of confidence levels, Harrington notes that evaluators should also be aware that managers with really deep knowledge in a specific subject area may actually appear underconfident. “The more one knows about a topic the less confident some managers tend to be,” she says. The true experts in a subject may in fact appear to be more tentative than neophytes. “In an environment attuned to big egos, the truly competent managers could easily be overlooked,” Harrington reports. “A savvy evaluator might see that the manager’s track record is due to a broader business background and a specialized information set that is difficult to duplicate. Such a person also knows what they don’t know and an expression of that is an indication of a true expert expressing underconfidence.”
Everyone is subject to biases but a good hedge fund manager is always alert to how his or her biases can creep into and contaminate the investment decision-making process. “We don’t cure biases we identify them and can take action to mitigate them,” says Harrington. “And once identified and emotionally accepted people do seem to be able to take different actions despite the bias.”
In summary, says Harrington, investment committees should always be looking for “considered responses” from potential fund managers, a balanced worldview that reflects confidence but also a disciplined and informed awareness of how their biases may be influencing how they invest.
An investment committee looking to detect confirmation bias in a fund manager might see it showing up “if he or she is stating that their strategy or execution is the only one in town,” says Harrington. If a potential manager is asked why their strategy might fall apart and if he or she says something like “all the research shows this strategy will continue,” the evaluator should probe more deeply into the manager’s thinking. “That response suggests the manager is either in denial or has not thought through the interactions of their strategy with other market participants and conditions,” Harrington maintains.
Harrington says that herding behavior, unlike confirmation bias, is fairly easy to identify, both for the manager and the evaluator. However, while “most professionals know when they are being caught up in it they nonetheless have a tendency to rationalize it,” she has observed. At the height of the dot-com boom and in the 2006 and 2007 subprime boom period, for example, those most caught in the herd mentality might have been likely to make pronouncements like: “it’s different this time,” or “there are structural changes going on in the market,” or “the new Fed monetary policy is a game changer and this subprime boom may continue,” or “it makes sense for these technology companies to have these valuations because they are the future of the economy.” An evaluator should take note when a manager makes such rationalizing statements.
In the behavioral finance literature, overconfidence is defined not so much as braggadocio or ego-driven behaviors but as “overprecision in the range of expectations for the future,” says Harrington. If a manager’s projections of their future performance or of the economy are too precise, it may suggest the sort of overconfidence that should be cause for an evaluator’s concern.
Overconfidence also shows up in two other manifestations says Harrington: when a manager overestimates his or her own performance in absolute terms and when he or she overestimates it relative to others. “So if for example they say that they are using a cross volatility arbitrage strategy and are the only ones in the market doing so, that should raise a red flag,” Harrington reports. “In the hedge fund business if you are the only one doing it today, there will be 50 people there tomorrow, and a manager who is not acknowledging that is reflecting a naïveté.” Follow-up questions might probe for the manager’s experience with other strategies that became too efficient to create alpha, and what controls the manager has in place to detect such a situation for his or her own fund.
The tendency to exaggerate one’s performance relative to others may be particularly pronounced with emerging managers because their track record is short. Overconfidence may look like a virtue because without it the emerging manager may not be able to make the sale. “But you should listen for an acknowledgement at some point indicating that the manager knows his or her track record is short,” says Harrington. “An evaluator might think in terms of distinguishing between confidence and what is in fact 'ego alpha.'”
Adding a layer of complexity to the subject of confidence levels, Harrington notes that evaluators should also be aware that managers with really deep knowledge in a specific subject area may actually appear underconfident. “The more one knows about a topic the less confident some managers tend to be,” she says. The true experts in a subject may in fact appear to be more tentative than neophytes. “In an environment attuned to big egos, the truly competent managers could easily be overlooked,” Harrington reports. “A savvy evaluator might see that the manager’s track record is due to a broader business background and a specialized information set that is difficult to duplicate. Such a person also knows what they don’t know and an expression of that is an indication of a true expert expressing underconfidence.”
Everyone is subject to biases but a good hedge fund manager is always alert to how his or her biases can creep into and contaminate the investment decision-making process. “We don’t cure biases we identify them and can take action to mitigate them,” says Harrington. “And once identified and emotionally accepted people do seem to be able to take different actions despite the bias.”
In summary, says Harrington, investment committees should always be looking for “considered responses” from potential fund managers, a balanced worldview that reflects confidence but also a disciplined and informed awareness of how their biases may be influencing how they invest.
—Susan Arterian Chang is a financial writer based in White Plains, New York, and publisher of The Impact Investor, a project of The Capital Institute.
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