The Epsilon Theory site has an insightful post by contributor Matthew Edwards critiquing the seven rules that allocators often apply to new fund managers.
The seven rules are:
- We don’t do crypto.
- We only invest in what we know.
- We never pay full fees.
- We prefer fundamental investment strategies.
- We seek strong alignment of interests.
- We cannot be greater than x% of a fund’s total assets under management.
- We require a minimum track record of X years.
Matthew Edwards is, in his own words, “a former allocator, 2x emerging manager, news junkie, and Twitter doomscroller.”
The post cites numerous sources in academia (blame aversion), behavioural finance (story telling), and legendary investors (Warren Buffett, Stephen Schwarzman) to make the case for allocators being stuck in their own self-serving paradigm when assessing emerging funds.
“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.”
On the one hand, allocators are the subject matter experts and gatekeepers.
On the other hand, because fund allocation can be as much an art as it is a science, career allocators are willing to accept mediocrity over performance, status quo over risking one’s reputation.
Two citations that are most interesting:
An observation from Yale endowment’s David Swensen.
“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.”
An academic study of what many of us on the fund management side of the table intuitively know: Past performance is not an indication of future results; relationships matter for fund allocation; and funds that are picked because of relationships do not generate higher returns or lower fees.
“Two factors play an influential role in choice: pre-hiring returns, and pre-existing personal connections between personnel at the plan (or consultant advising the plan), and the investment management firm. While relationships are conducive to asset gathering by investment managers, they do not appear to generate commensurate benefits for plan sponsors via higher gross returns or lower fees.”
As the saying goes, “Don’t hate the player, hate the game.”
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