Last week we told you about a curious market inefficiency – the fact that Asian-focused hedge funds with local offices performed significantly better than Asian-focused hedge funds with no local offices in the region. It was curious not necessarily because you’d expect otherwise, but rather because the anomaly seems to be ongoing. In other words, the invisible hand of the market has not arbitraged it away with its usual gusto. We drew on Andrew Lo’s Adaptive Markets Hypothesis to account for part of this phenomenon.
Here’s another weird market anomaly that seems to be in no hurry to arbitrage itself out of existence. Individual investors who invest in mutual funds via financial advisors do markedly worse than those who don’t. This begs the obvious question “why do mutual fund investors even employ financial advisors?”
Professor John Haslem (see previous postings), the author of an article on this question in the upcoming edition of the Journal of Investing, doesn’t mince words. In an earlier version of his article he writes:
“The actual returns on mutual funds earned by investors are much lower than the rational behavior paradigm of financial economics would suggest. Certainly this is evidenced in the performance of funds distributed through the advisor channel. From the evidence here and elsewhere, much (if not most) of how and where investors go about investing in funds has behavioral biases as well as other behavioral and knowledge overtones.”
We’re always interested in “behavioral biases” because when you boil it right down, they represent one of the few logical explanations for the continued existence of recurring alpha in hedge funds or traditional active funds. So we posed a few questions to Haslem, who is the author of dozens of other interesting papers on mutual funds and Professor Emeritus at the University of Maryland. Here are his answers:
AllAboutAlpha: Professor, the hedge fund community is always interested in the supply of alpha. Is it finite? Is it decreasing? Is it a renewable resource? Could investor inertia (and other factors enabling the perpetuation of underperforming mutual funds) represent a continually replenishing source of alpha for the active management community (of which hedge funds represent a disproportionate share)?
Haslem: The supply of alpha in hedge funds is limited only by the ability to develop sound strategies tested to generate alpha. To the extent such strategies are developed, the result will be more opportunities for sophisticated investors to find alpha in actively managed funds. Mutual funds will continue the march to indexing, and for alpha generation to rely more so on smaller boutique fund companies with proven histories of superior performance.
AllAboutAlpha: Pensions are often viewed as deriving non-economic utility from their investments (like farmers or other types of hedgers). In other words, their investment strategies are relatively constrained. If retail investors are constrained by the list of funds available in their DC plans, then are those retail investors also giving up their lunch to the less constrained alpha hunters?
Haslem: Depending on the funds available in DC pension plans, retail investors could find alpha with the right portfolio managers and investment objectives and strategies, but, in general, plan funds and portfolio managers are not likely candidates for alpha. Thus, under current conditions, the unknown opportunity cost of owning these funds is no alpha.
AllAboutAlpha: How to you define irrational? In other words, how can the value created by the ancillary services (e.g. life event planning) and value propositions (e.g. convenience) of a financial advisor be delineated from the fee structure? Is there a way to count the soft value created by the handholding?
Haslem: I use the word “irrational” in contrast to the rational decision maker assumption in theory. The value some advisors provide in assisting less sophisticated investors with behavioral biases to make financial life decisions, conveniently, and with reduced stress of failure should be in addition to superior performance, not a substitute. However, many of these investors are guided into high cost low performance funds without their knowledge, and with the likelihood they will remain so invested.
AllAboutAlpha: And a related question: Does the satiation of purely behavioral biases actually have a value as well? For example, marketers might refer to your notion of framing as just branding and say that it is a legitimate part of the product’s value and therefore represents x% of the price people are willing to pay.
Haslem: Advisor satiation of investor behavioral biases does have a feel good value to less sophisticated investors, but at the risk of owning high cost low performance funds. To the extent this is true, this is not a legitimate service to investors, but rather a cover for selling them poor performing funds. The investors’ unknown opportunity cost is no alpha.
AllAboutAlpha: If funds flows are positively related to the size of the complex since larger complexes = more free media (in database listings or otherwise), then do you think deregulation of hedge funds down the road might give rise to a dramatic increase in the number of funds offered by each firm? Have we seen any such development as a result of brands such as Morningstar and others getting into the hedge fund database game.
Haslem: Deregulation or less regulation of hedge funds will lead to an increase in the number of funds. This is proper if expansion is based on additional sound strategies that have been tested to provide alpha. Expansion will also lead to larger complexes with increased opportunities for economies of scale and scope, as well as additional media and data base coverage, which also leads to greater profits for fund managers.
Unlike many academics, Haslem offers some pretty specific advice for retail investors: use fee-based financial advisors. We would definitely concur since fee-based advisors are essentially free of the behavioral biases that prevent them from offering bifurcated alpha/beta solutions â€“ biases caused by the absence of 12b-1 fees and other incentives to sell ETFs (beta) and hedge funds (alpha). By making decisions that are less influenced by behavioral biases, fee-based advisors might be less likely to feed their lunch to the alpha-hungry hedge fund community.