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Monday, October 12, 2009

Behavioral Finance Is Very Useful..But I'm Not So Sure About Actively Managed Funds Based On Behavioral Fianance

As readers here know I am a big believer that behavioral finance offers some extremely important insights. In my view behavioral finance offers some insights that pretty decisively make the case that markets are not always the "rational" market posited by what is called the strong form of the efficient markets theory.

On the other hand I find it hard to argue against with Richard Roll of UCLA and others that have pointed out that the insights of behavioral finance do not discover "inefficiencies" in the market that can be systematically exploited for profit. In other words the "weak form" of the efficient markets theory still holds it is very very very difficult to systematically beat the market with any investment strategy.

Hence I am quite skeptical that investors will find much consistent success in moving their monies from index investments to the group of actively managed funds, using the insights of behavioral finance in their strategies The nyt ran an interesting article on these funds.

my bolds and italics

October 11, 2009
When Emotions Move the Markets


....Some portfolio managers, adherents of an academic discipline called behavioral finance, say that there is no “if” about it. They contend that investors are driven largely by emotions, the sort so vividly on display in the stock market during the last year.

Those emotions cause investors to misjudge the impact of events in systematic ways, the theory goes. Identifying these patterns and trading against them, the managers say, allows them to enhance performance.

“Humans are emotional individuals, and that gets exaggerated when it comes to taking risks,” said Christopher Blum, chief investment officer of the U.S. Behavioral Finance Group at J.P. Morgan Funds. “There are errors that investors make. We try to exploit anomalies in valuations and momentum” arising from those errors, he added.

Behavioral finance funds in Morgan’s Intrepid and Undiscovered Managers series and in the Highmark, LSV and Allianz Nicholas-Applegate families, among others, often use “quant” or “black box” models. These are software programs that sift through data on thousands of stocks in a quest for those affected by such investor traits as “anchoring” and “herding.”

Anchoring occurs when new information about a company’s prospects arrives and analysts are reluctant to alter their forecasts, which would be a tacit acknowledgment that their initial efforts were off the mark. The absorption of changed circumstances is drawn out enough to allow funds that react fairly early to benefit, managers say.

“Investors tend to underreact to positive fundamental change,” said Horacio Valeiras, chief investment officer of Nicholas-Applegate Capital Management. The full response to events “comes over time,” he said, as investors abandon “behaviors that are weighing them down.”

This seems to be arguing that not only does the market systematically "misprice" assets as prices do not adjust to new information, but that there is a way to systematically detect these mispricings and profit from them. This may be trued on occasion but as Keynes has pointed outone can run out of money before the market proves you right. Of course if this strategy is not implemented on a leveraged basis or with shorting, one may not run out of money but one must be willing to ride out long periods of losses. And again the fact that such mispricings may occur doesn't mean that a particular strategy will find and profit from them on a consistent basis.

Herding amounts to investors collectively saying, “I’ll have what he’s having.” A trend develops and newcomers latch onto it, reinforcing it and making it look profitable. That brings in more investors, and the cycle continues until valuations are stretched, often to nonsensical extremes, before snapping back when little money remains to keep it going.

The tech bubble in the late 1990s was a notorious example. Another, in reverse, was the overall market collapse last fall and winter. Selling begat selling, and the lower prices went, the more it confirmed — for a while — that selling was the right thing to do.

When herding occurs in a market, behavioral finance funds try to profit by recognizing that the valuation extremes are unjustified, and buying or selling accordingly.

This one presents a bit of a a paradox as well. Firstly the same problem exists here as with the earlier strategy. The "herding" can continue for a long time and if the strategy entails shorting the overvalued assets
one can run into the keynes dilemma.

Research has pretty definitively found that there is a momentum factor in markets and certainly a strong case can be made that it is best explained by behavioral economics.

However it does not at all follow that the best strategy in light of this herding phenomenon is to buy or sell in the opposite direction of the herd. In fact many studies (and a significant number of traders) would argue the best strategy is to ride the momentum along with the herd (and presumably get out before the inevitable bursting of the bubble). For example a recent study of hedge fund behavior during the tech bubble found they were heavy buyers of what were the most highly valuesd stocks. In other words a significant number of the "highly skilled" traders saw the best strategy as riding with the herd rather than following it. And many value traders such as the legendary Julian Robertson lost masses amounts of money shorting tech stocks too early,Secondly one could argue that the recognition of herding in financial markets would argue for a strategy that would attempt to identify stocks or sectors with high levels of positive price momentum and to "ride" the momentum rather than to try to short the overvalued stock with positive momementum.

So once again behavioral finance has given us an important counter to the "strong form " of the efficient markets theory that price reflects value with the evidence of herding and momementum which creates bubbles and busts. But the "weak form" of the efficient market theory seems to still win out. Knowing that bubbles and busts occurs does not mean that one can spot extreme overvaluation or undervaluation, nor does it rule out a strategy of riding mommentum rather than trading against it.

So I was not surprised that when tested with mutual funds it seems clear thatjust because one has identified behavioral distortions in the market doesn't mean one has identified a path to profits:

Although the role of emotion in investment may seem undeniable, especially lately, behavioral finance remains a niche discipline among investment professionals and academics. (Funds in Morgan’s Undiscovered Managers series have “behavioral” in their name, but many others that use behavioral techniques don’t.)

The more popular school of thought, the efficient-market theory, is based on the idea that asset pricing is rational and nearly perfectly reflects available economic and corporate information.

The main point in favor of efficient markets is the widely observed inability of active portfolio managers to beat market averages. If markets were inefficient, there should be more evidence that investors with certain skills could beat their peers consistently and predictably.

Followers of behavioral finance see high volatility and trading volume as confirmation that emotion plays a significant role in markets. If everyone has the same information and understanding, why do markets move at all, except for the few minutes or hours after major news? And what is the point of trading securities at any other time?

The above is a bit of a simplistic dichotomy between efficient markets theory and behavioral finance. One can believe (as I do) that behavioral finance has much to say about how markets behave, that overshooting and herding (momentum) exist without believing that investors have the skill to systematically beat the market>

Prof Goetzman (cited below) is certainly far more knowledgeable than I am, although I did search for any writings by him that support his quote below:

Will Goetzmann, director of the International Center for Finance at Yale and an authority on behavioral finance, said advocates of efficient markets had begun to concede that there is a sizable psychological component to trading. And a grudging recognition is emerging that there are meaningful differences in talent, he said.

“There has been a reversal of this notion that there isn’t any skill out there” among fund managers, Mr. Goetzmann said. “Research is finding that there are managers that have more skill than others and provide risk-adjusted value.”

Furthermore even if there are managers that are able to provide higher risk adjusted returns (that elusive alpha),it seems doubtful that individual investors will be able to benefit from that alpha through the retail behavioral finance oriented funds:

Whether many of those who run behavioral finance funds are among them is questionable. Many have produced results over the last 12 months that are in line with the broad stock market. They have also displayed slightly higher volatility. And as paradoxical as it seems, the comparative performance of these funds tends to diminish during periods of peak emotion. Managers point out that behavioral finance techniques work better when the craziness that distorts markets abates, not while it is in full force.

The funds tend to be small, too, and therefore can have high expenses, often close to 2 percent of assets. That erodes returns even in the best of times.

Academic research has certainly identified that there is a momentum effect as well as a small and value premium. Eugene Fama, the researcher most responsible for identifying the small and value premium is also considered the father of the efficient market hypothesis. Thus for Fama the only explanation for the outperformance of small and value stocks was that they must be riskier.

Yet many researchers from the behavioral school accepted the outperformance of small and value stocks but attributed this to behavioral factors: investors flock to "glamour stocks" bid up their prices and valuations until they ultimately collapse in price, while undiscovered value stocks are ignored until they return to a value that more reflects their fundamentals. Hence the behavioralists become advocates of value strategies but with a rationale far different than that of the researcher than initially discovered this "anomaly". Fama's firm Dimensional Fund Advisors was the first to offer low cost passive (index) instruments concentrating on small and value stocks. Interestingly (DFA) has also begun to incorporate a bit of a momentum weighting in their investment strategies.

So where does this leave an investor who is looking for a way to possibly take advantage of the insights of behavioral finance in his investing strategy. It seems to me there is an alternative to investing in an expense black box strategy. Incorporating a position in one's portfolio with a small cap value index instrument would be a way to exploit the markets tendency to undervalue this sector. But of course this comes with the caveat that one must have the patience to hold this position during the inevitable periods of underperformance.

A morningstar analyst quoted in the nyt makes a similar point:

Christopher Davis, senior fund analyst at Morningstar, is reserving judgment on behavioral finance funds, which he considers to be undergoing their trial run. But he is generally unimpressed so far. “It’s fair to say that it’s an emerging academic discipline,” he said, “and its application as an investment discipline isn’t all that far along.”

It’s not clear what significant advantage can be gained from understanding the mechanisms driving investors’ psyches. Just as someone sitting in a tree does not have to be Isaac Newton to know that falling out of it can hurt, an investor ignorant of the inner workings of his peers’ minds can still recognize the merits of a stock that’s cheap relative to the company’s profits.

“The bottom line here is that there’s a fancy theory underlying all these funds, but what they’re doing isn’t all that revolutionary,” Mr. Davis said. “TThey use quant screens to look for the cheapest stocks, but that’s what fund managers have been doing for a long time.”

And of course there is a low cost way to buy "cheap" stocks: a value oriented index fund or etf.

And then there is the behavioral paradox of any investing strategy whether using a value weighted index instrument or an active behavioral fund:

“Be sure you aren’t falling into any of the behavioral traps,” Mr. Davis advised. “It would be really kind of ironic if you invested in a fund based on behavioral finance and you sold it after the fund had a big loss or added to it after it was up 50 percent.”

“It’s hard not to be human,” he added.

Behavioral finance has given us great insights into the factors that produce market volatility, momentum and overshooting and asset bubbles. It does not seem that it may provide a means for capturing that elusive alpha by exploiting these phenomena on a systematic basis. Adding a bit of a value "tilt" through an index instrument may be one approach. There may be some promise to incorporating some recognition of momentum into a strategy.

In other words if there is a way to profit from the phenomena found by behavioral finance the best way to do so may be with a low cost value index instrument rather than an expensive actively managed behavioral finance mutual fund.

But the best use of behavioral finance may be in recognizing when one's investment behavior corresponds to one of the pitfalls identified by these researchers:

Resist the temptation to follow the herd and buy high and sell low.
Resist the temptation to buy highly valued glamour stocks.

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