Do Behavioral Funds Work?

April 7, 2010

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Do Behavioral Funds Work?

Businessmen in jungle with machete and idea lightbulbs

No. Maybe.

For all the impressive research on behavioural finance the acid test is ultimately whether it can yield better returns for investors. A few intrepid souls have set out to discover whether there’s any evidence that investing along behavioural lines can produce such returns and have re-emerged from the mutual fund jungle, somewhat battered and worse for wear, with the broad answer of, err, “No, it doesn’t”.

Of course, there’s a bit of a puzzle behind the research because the concept “behavioural investing” is somewhat amorphous. It would be unsurprising, given the parasitic mutational qualities of the financial sector, if the rise of behavioural finance didn’t attract managers who see it as the next destination of hot money. It’s enough to make your head spin: behavioural finance itself could be the next behavioural finance anomaly.

Behavioral Funds

In Behavioural Finance: Are the disciples profiting from the doctrine? some researchers from Florida State have taken a hard look at the rise of the behavioral mutual fund to try and figure out if these vehicles are providing investors with abnormal returns: that is, returns above and beyond what you might expect to get from simply investing in the market. The idea that the subject is a religion, its promoters disciples and the approach doctrinaire seems to beg the question a bit, but as an inveterate question beggarer myself I reckon we can reasonably skip that and look, instead, at the data.

Now, the idea of a behavioral fund is a bit dubious in itself. Behavioural finance research shows that markets exhibit anomalous behaviour unpredicted by standard economic models while also showing that investors are predictably irrational in a variety of peculiar ways. The research has also been able to show correlations between these findings and thus explain various market anomalies. So far, so good.

From Market Anomalies to Investor Irrationality

However, we’ve also seen that merely pointing out these anomalies is often enough to cause human behaviour to adjust to make them disappear. The idea that markets are adaptive is a strong theme in finance at the moment, and the evidence is compelling if not yet overwhelming: one of the problems of adaptive models is that they can pretty much explain anything which, if not controlled for carefully, means they explain nothing. Still, it very much looks like changes in human behaviour can explain extreme changes in markets.

This, however, is a long way from being able to use behavioral finance to directly make money out of it. Individuals, recognising their own psychological weaknesses, can undoubtedly improve their investment performance over extended periods: even if this merely means moving from a scattergun activist approach to a more passive buy and hold one. There’s also the intimation of an idea that rational investors may be able to detect the various extremes of irrationality: unfortunately it seems it may actually be quite difficult to make money by betting against the markets at peaks because the market will have been captured by zealots. It’s probably a bit easier in the troughs.

However, peaks and troughs are extreme events, by their very nature. Despite the nasty reality that extreme events occur far more often than classical models predict they’re still relatively rare. Mostly markets wiggle about between extremes and alpha seeking fund managers – that happy breed who seek to show that they can produce risk-adjusted returns in excess of the market while drawing their fees regardless of performance – must live with this environment while trying to make a turn. So a behavioral fund will somehow have to find a way of making money from human misbehaviour during normal times.

More Investment, Less Returns?

When the researchers from Florida examined a list of sixteen funds they identify as following behavioral principles they found that these funds were successful at attracting excess investment dollars, suggesting that the buzz around behavioral finance is penetrating some part of the mass investor psyche. It’s interesting to note that the researchers generally base the fund starting date from the arrival of a manager known to be associated with behavioural finance: nothing wrong with that in research terms but highly interesting in respect of the relationship between investment funds and star managers.

Moving along, however, we discover that the researchers find no evidence of abnormal returns in these funds although they do find that they’ve outperformed the S&P500. What’s really interesting, however, is that the reason for this outperformance appears to be a loading on the French and Fama HML factor. HML – High Minus Low – is a value measure, essentially indicating the premium to be obtained by investing in stocks with a high book to market value over their supposedly more growth oriented cousins. In straightforward terms the behavioural funds appear, over the period measured, to be emulating value funds.

A Behavioral Fund Bubble

Now, of course, this isn’t conclusive. Over the period in question value funds did outperform, so you’d kind of hope that behavioral funds would track this outperformance. The acid test is that by the time value starts to underperform then the behavioral funds should have switched tack and be following whatever the alternative theme is that is attracting the crowd. Quite how behavioural finance helps you develop foresight of this kind isn’t clear, but perhaps if the rise of behavioural finance continues then a good bet would be to start tracking behavioural funds. A behaviourally induced bubble in behavioural funds would, at least, be a mildly amusing artefact of the whole, strange situation.

It’s genuinely impossible to know whether funds labelled as being “behavioral” are somehow able to implement a strategy that will outperform other approaches over significant periods of time. In fact we don’t even know if these behavioral funds are actually operating on the principles of behavioural finance (whatever they are). As the researchers put it:

“The mere statement that a fund uses behavioral finance in its investment decisions offers no guarantee that it really does. Also, it is possible that the only funds admitting the use of behavioral finance are those that are prospering from it. There could be a larger group of funds using behavioral finance but not talking about it because of poor performance. However, we believe this potential selection bias strengthens the main conclusion of our paper.”

Alice in Behavioural-land

Well, maybe. Or maybe those funds that use behavioral finance but don’t admit it have figured out that if they talk about it that it’ll stop working? On the other hand, if behavioural finance is the next hot sector it’s kind of hard to believe the mutual fund industry would be shy about publicising this. Also underperformance might be because there are genuine behavioral strategies which work, but which can’t be implemented due to costs – nice clean academic theories are often sunk by nasty real-world facts.

Still, what we do know is that hot fund sectors which attract excess amounts of investor money tend to lead to investor underperformance: if only because investors who are attracted to hot money tend to be serial flippers of funds. It’s all horribly Alice in Wonderland-ish but the acid test will, as usual, be time and investors’ capital.