Take Note: Diane Garnick Is at the Cutting Edge of Finance

MINYANVILLE ORIGINAL Diane Garnick is the kind of cheerful person whose Ciceronian eloquence and rhetorical chops force one to stop, think, and finally realize that there's little blocking the progress of what people used to call-and still call, now and then-the human spirit. At the Exchange Traded Fund (or ETF) conference where I met her a few weeks ago, she declared during her panel, "The only thing that limits you is what you think limits you." That's not to deny the existence of limits altogether. Diane instead claims that the brain donates all obstacles, courting both psychic and real imbalance. If limits result from our own neuroses, then Garnick has clearly passed through this drama, if not, to an extent, triumphed over it. Just such a tension between thought and reality situates Garnick's trading method. Her area of expertise is wedged where the psychological meets the concrete: Diane is the Chief Executive Officer of Clear Alternatives LLC, one of Wall Street's first firms to merge behavioral economics with fundamental and quantitative modes of analysis. Clear Alternatives opened on January 19 of this year and manages assets for pension funds, endowments, and family offices. Its staff also happens to be female.

Diane Garnick at the Clear Alternatives offices

Building on Harry Markowitz's momentous portfolio theory (which is more or less a theory of risk-weight), behavioral economics synthesizes psychology and economics, its approach lying somewhere in between them. "Classical economics," Garnick, 45, summarized in a phone interview, "says that people go around throughout the course of their day, calculating exactly what they're supposed to do at each and every moment. Psychologists say that nobody does that. Somewhere in the middle lies the truth." She recently received a Master's degree in the subject from the University of Chicago, where-as just about zero readers don't already know-modern American economics more or less began. But her firm tries to apply the method with as little doctrinaire narrowness as possible. Garnick instead believes that behavioral economics is a tool for the common investor. Before elaborating on the use Garnick makes of behavioral econ, it would perhaps not be inapt to provide a brief history of her winding finance career.

A New York City native, Diane was one of the first women in derivatives. She cut her teeth researching huge derivative products for companies like Morgan Stanley (NYSE:MS) and Merill Lynch (NYSE:BAC), beginning in 1998. She then began researching the same products for Invesco (NYSE:IVZ), where she focused by and large on portfolio construction for pension funds. "Before Bernie Madoff," she said, "I thought that I worked for the teachers, firemen, policemen, and so on," who are all, ideally, the beneficiaries of a pension fund. But since Madoff, Garnick has learned that she finally answers to the taxpayers: Tax increases often result from imprudent risks in pension fund diversification.

Diane debuted as both a fundamental and quantitative analyst. Clear Alternatives uses a, well, alternative kind of analysis, tempering the often unchecked biases of quantitative and fundamental approaches. (For clarity's sake, quantitative analysis derives risk levels, portfolio strength, etc., from algorithms and mathematical formulas; fundamental analysis studies the statements and quarterly reports tendered by specific businesses, as well as macro figures in what's called a top-down approach.) In short, Diane claims, the basic principles of behavioral economics-such as, for instance, the idea that your average rational decision stems at least in part from a private and likely irrational compulsion to do one thing rather than another, without any rational basis-can ease the effects of a blinkered will, normally neglected in the name of raw fact.

When asked how ETFs fit into her research methods, Diane said, "Our focal point of Behavioral Economics is complemented by two specific types of ETFs, the select sector SPDRs, which enable us to quickly express our views in the ever changing markets"--such as Consumer Discretionary SPDR (NYSEARCA:XLY) and Consumer Staples SPDR (NYSEARCA:XLP)--"and volatility based ETFs, which help us produce returns with lower levels of risk." Examples of the latter include S&P 500 Dynamic VIX (NYSEARCA:XVZ) and S&P 500 VIX Short-Term Futures (NYSEARCA:VXX)

"We know," she said, "that people make bad decisions-their decision-making process is not very fine-tuned. Some very famous economists claim that that's because of biology; other people claim that it's because of social conditioning. So we try to identify all of the decision-making biases that pose risks to our investors' profit. And then we reduce those risks as much as possible." Reducing biases is clearly the easy part-the crux of the process lies in picking them out.

Here's an example: Clear Alternatives structures its investment committee meetings using what Diane calls the Socratic Method, after the famous Greek dissident's style of debate. One manager spends the day collecting data in favor of, say, General Motors (NYSE:GM). Another manager delivers reasons to avoid it.

What's the rationale behind CA's division of labor? Diane explains it by way of analogy. Let's say, paraphrasing her, that a man has been seeing a woman-supposedly, this happens fairly often in the modern world. He lists in his head a few traits of hers that he likes and a few that don't drive him wild. Finally he decides to tell a friend about her. "I met this great girl," he says. What he not only doesn't but can't say, Diane insisted, is, "I met this great girl, and here are all of the things I don't like about her." Behavioral economics has a name for this sort of trompe-l'oeil: The endowment effect. When I explicitly endorse something-a potential partner or a bundle of stocks-I become, whatever my will, committed (or condemned) to it.

So when a trader adduces reasons in defense of a stock for half of her workday, there's little chance that her opinion of it will emerge intact. In reality, behavioral economics tell us, she's already convinced herself that this stock, or sector, or style is worth whatever volume of risk it entails. So, again, one trader prepares a "pro" profile of the stock, using quantitative and fundamental resources, and another prepares the "con." So goes the Socratic Method, one of Clear Alternatives's many operations inflected by behavioral econ. But that's not the firm's only unconventional element. Its roster is also all-female, as mentioned above.

Diane's clear on this point: Clear Alternatives isn't a political intervention so much as a corrective to an industry that hasn't been overwhelmingly friendly to women (typically in an infrastructural rather than direct manner). CA's gender "imbalance," which is actually a rebalancing and an attempt to equalize the field, came about purely by chance. "As we started to speak to people," she said, "we were very fortunate to get Florina Klingbaum," one of the founders of Credit Suisse's alternative asset branch. Like many women in the industry, Klingbaum's career sustained a lapse due to her pregnancy. In an industry that evolves at a breakneck pace, pregnancy can be crippling to even a high-ranking trader like Florina-a wrong that Clear Alternatives does its best to address by hiring women who, after raising a child, have been effectively locked out of finance.

The touchstone of Clear Alternatives's female-focused hiring practices isn't, "We're women, so you should invest in us." Instead it's, "We have great returns, an all-star team of traders, and we happen to be women"-which isn't quite the opposite, because the fact of being comprised entirely of women certainly still colors the identity of Clear Alternatives but doesn't define it. It isn't--at its roots or through some political program--a woman's firm, but is rather a firm that supports women through what it does and not only what it says. Diane again: "We only want to hire the best people that are out there....Look, if you know a man who's as smart as all of these ladies, send him to us."

It makes one wonder, of course, whether there's some primordial tie between the insights of behavioral econ and the sort of investment firm that would believe in women the way that Diane's does. It makes one wonder-and also hope. "Being a woman gives us a very different perspective," Diane told me. "What we can deliver is a diversity of thought. And diversity of thought is as important as diversity of stocks and bonds."