The Investor’s Paradox

Book Review: The Investor’s Paradox by David Merkel, CFA of Aleph Blog

Investing is paradoxical, as many that read my blog would know. The market has cycles.  There are overall boom/bust cycles.  There are minor cycles between the major cycles.  Strategies fall in and out of favor.  What is an investor to do?  Even harder, what should one who selects assets managers do?

It is hard to select talented investment managers.  I know this, because I have done it many times in my career.  This book points out the difficulties in selecting managers.  Were the returns due to skill, or did he hit a lucky streak?  If you are looking at the numbers only, it would be hard to tell.  Asking managers detailed qualitative questions could help, as could looking at the current portfolio, and asking:

The Investor’s Paradox
The Investor’s Paradox
  1. Does the portfolio fit the stated style of the manager?
  2. Does it fit his description of how he tries to make money?

This book summarizes many issues in picking managers:

  • Strict mandates vs looser mandates
  • The ways in which we deceive ourselves willingly, to believe a nice manager, or con man
  • How hedge funds grew and changed
  • Can managers adapt to new market environments successfully, or should they persist with their model which used to work, but is now out of favor?
  • How do you deal with funds that are too complex for the ordinary retail investor to understand? (I would say avoid them.)

The book includes a chapter on Madoff, and while it doesn’t break new ground, it does point out why custodians and auditors are important.  If there had been an independent custodian, or a real auditor, Madoff’s scam could never have happened.  I also appreciated the reference on page 125 as to the methods that scammers use to gain the confidence of those they scam.  This is one case where bright people get fooled.  I would encourage readers to read “The Big Con,” or even marketing books, to make themselves skeptical.

The book has a firm hand on what leads to risk/return among managers — Concentration, Directionality, Compelexity, Illiquidity, and Leverage.  LTCM is held out as an example of a disaster waiting to occur.

The book explains different types of investors, and why they take the risks they do.  Different investors take different risks.

The author gives his own summary of how to interview fund managers, though I found it to be light.  As a former buy-side analyst, I had to interview CEOs, and while I used a few techniques of the author, there are more techniques that can be used.  I appreciated the allusion to “Colombo,” because purposely dumb questions can reveal the honesty of the one being interviewed, and may reveal details that could not be gotten through a smart question.

At the end, he points out how pension plans will not be likely to meet their return goals.  He is right, and efforts to break that paradigm through allocations to alternative investments are also unlikely to work.  Hedge funds don’t respond well to volatility.

This is a good book, but I have one further main objection.


When the author discusses Simon Lack’s analysis of hedge funds (P 190), he wrongly dismisses the significance of dollar-weighted versus time weighted rates of return.  If a manager’s returns are so volatile that it leads investors to buy high and sell low, that is the manager’s fault.  Good managers limit risk so that their investors don’t panic.  Also, since dollar weighted returns are what investors receive as a whole, that is the actual result of the investing, and is the way that all investment managers should be measured.  And as such, Lack’s arguments are correct.  Investors would have gotten more out of investing in T-bills, which absolutely, would not be much more, but less is less.  Lack is correct, and the author is wrong.

Also, it should be noted that value managers have client bases that often invest more in bad times, and take profits in good times, so their dollar-weighted returns are often higher than the time-weighted returns.  Educated, contrarian investors do better.

Who would benefit from this book: If you hire mutual fund managers, you could benefit from this great book.  If you want to, you can buy it here: The Investor’s Paradox: The Power of Simplicity in a World of Overwhelming Choice.

Full disclosure: I asked the PR people for a copy of the  book, and they sent it.

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