The Homophily of Hedge Fund Culture

Approaching the end of a series of postings on social science research into investment culture, we come to the question of the lack of diversity in the ranks of investment professionals.

This time the research concerns hedge funds; it is the work of Megan Tobias Neely, in an article she wrote for Socio-Economic Review (“Fit to be king: how patrimonialism on Wall Street leads to inequality”) and her 2022 book, Hedged Out: Inequality and Insecurity on Wall Street.  (Quotes in this posting come from those two sources.)

Any academic-goes-into-the-investment-world endeavor presents the opportunity for an experienced practitioner to nitpick about this and that, including little details and big conclusions.  Neely’s work is no exception, as you’ll see in the comments on her big conclusions further down.  Of importance, though, is how well she captures the cultural dynamics at hedge funds regarding gender, race, and socioeconomic status.  (For the sake of brevity, this posting primarily will deal with issues related to gender.)

Homophily

Literally meaning “love of sameness,” homophily can be more thoroughly defined as “the tendency to form strong social connections with people who share one’s defining characteristics, [such] as age, gender, ethnicity, socioeconomic status, personal beliefs, etc.”  Through her interviews, Neely documents the homophily that pervades most hedge fund cultures.

Hedge funds are not alone in that regard — many investment firms are essentially monocultural, even as that condition has become much less common in other professions.  Some investment organizations, especially larger ones, have made strides in diversifying their employee ranks.  Others have not changed their historical hiring practices, looking and functioning much as they always have.  That is most prominently the case among “alternative” asset managers, including hedge funds.

While not all of those firms would fit under the common definition of “shadow banks,” they usually stand apart from more mainstream entities, fitting the ethos expressed here:

Growth in shadow banking is perhaps a sign of a retreat from bureaucratic institutions and a shift toward smaller firms funded through trust networks. . . . To guard against risk and uncertainty, people place trust in tight-knit forms of social organization.

The firms eschew diversity in the name of “meritocracy,” although a close look at how they operate indicates that is often an illusion.

The pipeline and the hurdle

Much of Hedged Out is organized around chapters about stages in the careers of hedge funders.  The first of them, “Getting the Job,” deals with the difficulties of those who are viewed as not having the typical profile for someone at a hedge fund.  That is, lacking “fit.”  According to the author, “Fit is a euphemism for social class but also contains implicit meanings about gender and race.”  The norm is hiring white men; “men blend in more and are routinely endorsed by other men, which is naturalized and framed as fit.”

Homophily is self-perpetuating.  Interviews of job candidates are often conducted by practitioners, who are not trained to look for true potential and how to develop it, but instead heavily weight “shared social and cultural experiences” when recommending or selecting someone for a role.  That often leaves out women, minorities, and those further down the socioeconomic ladder, all of whom are less likely to have had experiences that emotionally connect with interviewers.  Of the four main tracks by which people get into hedge funds, the “most common route to the industry” is the “social circle track.”  The book is full of examples of that in practice.

An additional challenge for women is the a stubborn belief in some quarters (famously articulated by Paul Tudor Jones) that motherhood disqualifies them from being great investors.  As a result, some firms have unwritten rules about not hiring women for direct investment roles.  And the kinds of informal activities at which social bonds can be formed (and job opportunities shared) are often men-only.  (A common explanation for that reality is that girlfriends and wives think it would be inappropriate to invite women to be included in such activities.)

When interviewing people about the lack of women and minorities in influential positions in the investment world, Neely found that they usually pointed to “a tried-and-true dismissive argument:  there are just too few members of these groups in the promotion pipeline or they aren’t interested in finance careers.”  Those are problems, but the larger issue is that firms don’t evaluate candidates on an equal footing; homophily creates a high hurdle that is difficult to clear for those who don’t fit the profile.

Internal barriers

Speaking of pipelines, should a woman land a job at a hedge fund it is likely to be in marketing, client service, or operations, rather than in an investment role.  (A tour of the “our team” sections of investment firm websites illustrates that this pattern is not limited to hedge funds.)  Investment duties tend to be gendered as well.  One story in the book is of “the girl” among eight incoming analysts, who was assigned coverage of retail companies (a traditional “girl” position in the industry) despite the fact that she had training in geology, while the men given responsibility to analyze energy and metals/mining had no relevant experience.

Overt discrimination and sexual harassment may not be as common today as they were during the time of Tales from the Boom-Boom Room, although the recent events at Odey Asset Management (covered in the last issue of the Fortnightly) remind us that they haven’t gone away.  That presents a dilemma for the wronged; in a tight-knit, reputation-based industry, those seen as rocking the boat by calling out bad behavior are likely to be black-balled.  (And when a perpetrator is let go, he usually shows up at another firm, an act of “passing the trash” that we’ve seen in other realms.)

Even when they are on the inside, women are often on the outside:

A fraternal environment and a hyper-masculine culture dominate the industry, limiting women’s ability to find mentors and networks.

Since the organizations are largely made up of men, informal activities and team-building events reflect their interests and athletic pursuits.  In interviews, even men acknowledge that it is hard to be a woman at a hedge fund — and founders often pass off their firms to sons but not to daughters.  One said he didn’t want his daughters to go into the business, “because it’s very much an old boys’ industry.”

The organizations

Hedge funds range in size from the proverbial “two guys and a Bloomberg Terminal” to very large firms, so generalizations are challenging, but there are common tendencies.  Organizations tend to be flat and often one person is the ultimate decision maker regarding investments (and most everything else too).

That entrepreneurial approach brings with it a lack of leadership and management expertise.  Leaders (who are primarily interested in and adept at the investment side of things) are “poorly equipped to provide training and mentoring.”  One significant problem is that “performance-based pay, throughout the industry, is subjectively determined and negotiated in what is, for the employee especially, a low-information environment.”  (Those with compensation arrangements explicitly tied to the performance of a portfolio are spared that murkiness.)  The result is two very different points of view at work in an organization:

Executives believed eschewing title and evaluations fostered meritocracy and creativity.  Employees, however, said procedural ambiguity led to dysfunction, bias, and unnecessary competition.

Ultimately, the success and sustainability of an organization is dependent upon building a culture that gets the most out of its employees — and brings in new talent that can help it grow in its capabilities.  A culture of homophily doesn’t do either.

Independent thinking

Neely relates the story of her own interview at a hedge fund in 2007.  She noticed a poster on the wall that said, “Respectfully Question Authority.”  It was one of several bromides “lining the hallway to communicate the firm’s values:  antihierarchy, antibureaucracy, and independent thinking.”  The interviewer subsequently explained, “We want our employees to be critical thinkers, not rule followers.”

In contrast, Neely’s later interviews with those who work at hedge funds found that the motivational posters didn’t fit with the environment.  People were “penalized for accepting the invitation to openness,” receiving “unwelcoming, even retaliatory, responses.”  That resulted in those involved — especially those perceived as outside the norm in some way — being “uncomfortable speaking up,” a natural response given the conditions, no matter what the posters say.  Independent thinking becomes less likely, not more.

Patrilineal propagation

Breakaway firms have long been a feature of the investment industry.  A person has success at one firm and decides to hang out their own shingle (or a group of people do so together).  As a result, some organizations have spawned impressive family trees over the years.

Most traditional organizations have not supported the breakaway process, not wanting to encourage their best people to leave.  That has also been the case with many hedge funds, but others have flipped the script:

Hedge fund founders provided valuable forms of mentorship, training, and seed funding to a select group of trustworthy, loyal protégés groomed to carry forward their investment tradition.

Neely calls these “cultivated” firms, with the Tiger Cubs being the most famous examples.  Who gets mentored and funded?  As with hiring, those choices “hinge on a sense of familiarity,” with predictable results in terms of race and sex.  In addition, it should be no surprise that there is portfolio herding and organizational replication within these extended tribes.  The networks are “based on trust, loyalty, and tradition,” whereby The Way gets passed down to the next generations of the clan.

Big conclusions

In the introduction to the book, Neely writes:

Elitism, whiteness, and masculinity largely determine who gets the W in this risky game, thought not always in predictable ways.  I close the book by arguing that, unchecked, this structurally unequal financial sector will accelerate inequality over time.  Systemic change is the only way to slow this concentration of money, status, and power into fewer and fewer hands, and to disrupt the economic dominance of elite white men that so forcefully forecloses upward mobility for everyone else.

This illustrates a question of scope regarding Neely’s work.  Her interviews with individuals paint a picture of hedge fund culture that is familiar to those who know the industry well.  But the broader conclusions often seem forced.

Do hedge funds cause societal problems such as inequality, reinforce them, or merely reflect them?  Are practices that prove to be exclusionary a sign of an intent to discriminate or evidence of shortsightedness and cultural inertia?  Those are complex questions.

Neely also delves into the “loopholes and legal exceptions” that provide advantages to hedge funds.  And comments that, like the large banks, “the hedge funds have very smart people who are paid to get around the rules,” putting the regulators in an unfair fight.

A decade ago, when The Wolf of Wall Street hit movie theaters, Neely wondered:

Why weren’t we looking at the perfectly legal, quotidian behaviors and banal job functions that create tremendous social problems, such as economic instability and socioeconomic inequality?

Her work offers insight into the quotidian behaviors.  However, the link to those important social problems is tenuous.

Practical perspectives

Among the important ideas prompted by Neely:

Social capital.  What comes through clearly is how important social capital is to the success of individuals wanting to make their way in the world of hedge funds, where that social capital seems particularly powerful (and narrowly drawn).  Those without social capital face huge obstacles to advancement.  Organizations should consider whether a constricted view of human capital — heavily judged based on social capital — is a tenable approach to long-term success.  There are certainly places to find diverse, equivalent talent should there be an interest in doing so.

Innovation.  Neely points out that Alfred Winslow Jones, “the hedge fund industry’s founding ‘father’ was a Marxist sociologist.”  (That part of the origin story isn’t usually highlighted.)  He used social theory to understand market behavior — “and then applied technical and mathematical methods to capitalize on social phenomena.”

What would Jones think about “hedge funds” today?  The term is now applied to an incredible range of strategies, many that don’t feature the hedging that Jones employed.  But despite the array of approaches and big changes in the universe of securities used, a remarkable sameness in culture is in evidence across many of the firms.  That fits a general pattern in the industry well beyond hedge funds:  “investment organizations” think a lot about investments and not much about what it takes to build a great organization.  Given his sensitivity to social phenomena, you’d think that would cause Jones to raise an eyebrow.

Questions for allocators.  Institutional investors who select asset managers — especially pension plans, foundations, and endowments — wrestle with how to balance investment beliefs and organizational beliefs.  If they invest using hedge funds and other alternative managers (which almost all of them now do), Neely’s book offers a reminder that some corners of the markets are very much out of sync with the diversity initiatives promoted by asset owners.

But even those who are solely focused on prospective investment results should ask:  What cultural attributes lead to success?  Putting paper-thin motivational posters on the wall is nice, but how can an organization be created that actually lives up to those principles?