“When faced with a difficult question, we often answer an easier one instead, usually without noticing the substitution,” psychologist and Nobel Prize winner Daniel Kahneman wrote in his 2012 book
Thinking, Fast and Slow.
This is a common occurrence in everyday life. For example, a broad and difficult question such as “How happy am I with the way the last decade of my life has turned out?” might be substituted for a more superficial question such as “What is my mood right now?” Mr. Kahneman gives another, more investment-related example. If the question is “Should I invest in Ford Motor Co. stock?” the easier question to answer is “Do I like Ford cars?”
Mr. Kahneman would posit that the reason behind this question substitution is that the brain is actually built to be efficient. When presented with a difficult question, it saves time by substituting a similar question, allowing us to find intuitive solutions to complex questions. This is known as a heuristic: “a simple procedure that helps find adequate, though often imperfect, answers to difficult questions.”
In many ways, this time-saving mental tool is a miracle. If every difficult question that was presented to us required intense mental scrutiny, our brains would be full nearly to the point of dysfunction. On the other hand, this tool can be problematic; for example, in the investment world, our well-intentioned heuristics can actually cause us to make costly and damaging life choices.
It is with this mindset in behavioral finance that I approach the recent SEC announcement about the importance of carefully evaluating “mutual funds that act like hedge funds.”
APPLYING TO LIQUID ALTS
SEC commissioner Kara Stein's June 15 speech at the Brookings Institution in Washington gave the following warning: Complex and risky mutual funds and ETFs, particularly so-called liquid alts, “often operate in a gray area of mutual fund regulation.” She argued that while these products are sometimes marketed as liquid versions of high-performing hedge funds,
“they may be less liquid, employ more leverage, and invest in exotic and complex instruments.
It's no surprise that the SEC has grown increasingly interested in regulating alternative investments. An August 2014 Wall Street Journal article reported, “the Securities and Exchange Commission has launched a broad examination of alternative mutual funds, according to people familiar with the matter, kicking off regulatory scrutiny of one of the hottest and most controversial investment products to be offered to small investors.”
And why wouldn't they? As 2008 showed, complicated investment products can do devastating things when the risks aren't completely understood. With liquid alts, as with any investment, it's important to have as much information as possible before making the decision of whether to invest.
But I would give a word of caution: It is exactly when discussing difficult questions that we are most likely to substitute simpler questions. In this case, “To what extent should liquid alternative products be regulated by the SEC?” is easily substituted by another set of questions: “How averse am I to investment risk in general?” “How do I feel when I think about innocent investors being misled by major industry players?” “What did it feel like in 2008 when the industry virtually fell apart?”
THE HARDER TASK
It seems to me that answering this latter set of questions is not only easier, but also more palatable than a more nuanced argument of the importance of derivatives and other alternative strategies in today's market. It's easy to vilify liquid alts; it's much harder to draft the kind of regulation that allows an investor to make an informed decision about the risk-return profile of their investments.
Mike West is senior partner and chief executive of BPV Capital Management.
