Clark Cheng is the chief investment officer at Merrimac, a private investment firm based in Stamford, Connecticut primarily investing in hedge funds. Prior to Merrimac, Cheng was a hedge fund manager HSBC’s Alternative Investment Group. Before that, he performed hedge fund research at Guggenheim Partners and Morgan Stanley between 2002 and 2005.
Cheng holds an MBA from Duke University and a B.A. in business/economics and psychology from UCLA. He also holds the Chartered Financial Analyst, Financial Risk Manager and Chartered Alternative Investment Analyst designations.
Cheng was named on Trusted Insight’s 2016 Top 30 Family Office Investors. His interview is divided into two parts. In part one, he discusses how his academic background in psychology informed his decision-making as an investor and why he believes understanding human behavior is essential in any career. He also shares views on innovative investment products and why he thinks some can be problematic.
Trusted Insight: You studied psychology and business economics. How does your education influence your decision-making as an investor?
Clark Cheng: I think when you're studying, initially, you don't really understand the value that it will provide later on in your career. In hindsight, studying psychology and human behavior is actually more important to me than finance is. You have to understand finance as a foundation for being in this business, but the psychology is actually something more interesting and valuable in understanding human behavior—why people do things and the way they do them.
Trusted Insight: How have you seen your psychology education crop up in the investment world?
Clark Cheng: I studied psychology because I had an interest in it, and I wanted to understand my parents better. They were extremely overbearing and strict, and as a result I was trying to understand why they brought me up in such a tough manner. Initially, I regretted it, but over time I understand why they did it.
However, understanding human behavior is extremely important in any career, from negotiations to understanding how fees, alignments of interests and incentives impact people’s behaviors. For example, if some large firm buys out part of the equity or economics of a hedge fund, the manager will subconsciously behave differently because he doesn't get all the economics. As a result, he may not perform as well as he could have had he not sold any equity. Once you take more than 10 percent of a firm, the manager will have less incentive to perform, and he may or may not realize it.
In other situations, people say, "We want the manager to be invested with the LPs." I think that's true to a degree, but at some point, the manager will behave only in his self-interests because he has so much of his own wealth at risk in the fund.
People have very simple heuristics, but it's much more complicated when you really understand human behavior. Looking at investments from multiple perspectives is very important—you need to look at it from the perspective of finance, risk, operations, quant and human behavior. Having multiple perspectives helps you understand managers and allows you to make better investment decisions.
Trusted Insight: To extrapolate the theme further, how does your background in psychology factor into your selection of investment managers?
Clark Cheng: It comes down to incentives. What drives human behavior? As managers with a “2-and-20” fee structure become a certain size, whether it be $20 billion or $30 billion, it doesn't make sense to take risk anymore, because you're generating so much in management fees. Why take risks to generate a performance fee? You're making hundreds of millions of dollars in management fees as an annuity. Why take risks?
Likewise, when you bring in institutional capital. If you don't have the leeway to make true investment decisions, especially if you have clients, you tend to make decisions that are conservative and protect the business.
At every institution, it's in your best interests to protect your career. There are also competing interests from different stakeholders who have different goals and incentives. Some focus on fees whereas others focus on risk. As a result, you may not make the best investment decisions for the portfolio. This is true across the entire asset management industry, where different incentives motivate different behavior. It is truly hard to invest without having the culture and structure to do what is right for the portfolio.
Some institutions tend to exhibit a herd mentality. Institutions that use consultants will invest in funds that are on their recommended list, which will have commonalities based on how consultants are measured and compensated. If endowments are measured and compensated against their own peers, they will also exhibit behavior that differs from other institutional investors. Herd mentality manages the risk that you significantly under- or outperform your peers. The fear is that you miss out on a manager that turns out to be strong. If a manager underperforms, everyone is in the same boat.
Trusted Insight: Does that mean you are more free to take risk within a family office?
Clark Cheng: It is easier to do the right thing for the portfolio without external clients that have different needs and risk tolerances. Some people think that carry aligns interests, which it does to a certain point, but it also incentivizes a portfolio manager to take excessive risk to enhance their own reward.
There's a balance, and the key is to understand how to align the interests of everyone together so that everyone achieves the optimal goal. It's never as simplistic as people think. These are some examples of why I think the psychology background helps understand human behavior. If you understand why people do what they do, it is easier to understand capital flows.
Investing and making money are two different goals. Markets tend to be efficient over time and capital flows will eventually move assets to a fair valuation, but there is a lot of money to be made through this capital flow process. Understanding where capital flows are moving helps investors trade and make money, separating the top managers from the average manager. Most managers in hedge funds are excellent stock pickers, or otherwise they have a very short career, but portfolio and risk management skills are hard to source. There are three main levers to drive performance: gross (leverage), net (directionality/beta) and concentration. Managing net and gross exposures over different market environments as well as sizing up one’s winners at the right time, and vice versa, differentiate the top managers from everyone else.
Trusted Insight: How do you perceive seismic changes like Brexit and the U.S. election from an investment psychology perspective?
Clark Cheng: It’s very interesting. Uncertainty is taken out of the markets by having chosen a president, but there is still uncertainty with regards to the new president’s policies and what he will accomplish. As a result, it is creating opportunities, because investors have different opinions now regarding the president’s agenda and his ability to deliver. As long as active managers disagree, there will be winners and losers in stocks and subsequent dispersion in manager returns, which allow allocators a chance to perform. If everyone has the same views, there is no dispersion in manager returns which makes it difficult to generate performance allocating to active managers.
Trusted Insight: What’s your view on the impact technology -- such as artificial intelligence and machine learning -- is exerting on investing?
Clark Cheng: Nothing in this business is simple. Financial institutions are creating cheaper products to access hedge funds, such as smart beta and hedge fund replicators. Many products are based on academic research, which is highly biased based on the well-known problems with the public databases. Additionally, these products are designed to give an average hedge fund return, but not the top-quartile or decile, which is what most allocators are trying to achieve.
If this business was simple, and you could systematize it into some kind of algorithm, I don't think any of us would be in business. Perhaps asset allocation can be quantified into an algorithm, but selecting managers in the alternative business is more difficult. Widely accepted financial models, such as a Brinson Attribution Model, were conceived for long-only investing, but hedge fund managers manage net, gross and short exposure, and as a result, the entire model falls apart, especially because data is limited.
Trusted Insight: Why are research-based investment products problematic?
Clark Cheng: Reliable, robust data is the biggest problem in the industry. Selection bias, survivorship bias and voluntary reporting of performance to public databases create flawed research results. For example, if you analyze the public databases on the quant meltdown in 2007, the bottom quartile is not nearly as bad as it is in private databases where reporting is not voluntary. If a manager was using the database as a means to distribute and market performance, there is no reason to report your August 2007 number. If the data is flawed, the resulting research will be flawed too, creating misperceptions about the industry. Quantitative managers understand the value of robust data and will spend as much time cleaning the data as working on the model.
I think to succeed you have to approach investing from multiple perspectives, including psychology, finance, risk, statistics, etc. If you study decision making in teams, the question is: what's the optimal team size? Five is the optimal team size, but the number is less important than how the team is constructed. Decision making is most efficient and effective when the team is constructed with different perspectives and backgrounds. I think diversifying your approaches at analyzing managers is important in creating a robust portfolio of strong managers.
Investing is an art and cannot be simplified to a bot. Human behavior is not rational which machines do not understand. However, quantitative tools and technology combined with human intellect will always produce a better result.
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