Swedroe: Behavioral Finance Trumped

July 29, 2015

Richard Thaler, a professor of behavioral science and economics at the University of Chicago Booth School of Business, is widely considered one of behavioral finance’s founding fathers (along with Daniel Kahneman and Amos Tversky). His excellent new book, “Misbehaving,” is partly a history of how the field of behavioral finance originated and developed, despite hurdles created by the financial establishment.

Don’t Dismiss EMH

Thaler also discusses some of the more common investment mistakes arising from behavioral biases, as well as a behavioral explanation for the equity risk premium puzzle. Today however, we’ll take on Thaler’s thoughts in “Misbehaving” regarding two key issues related to the efficient markets hypothesis (EMH).

First, as a descriptive model of asset markets, Thaler gives the EMH a mixed report card. Regarding the “no free lunch” component of EMH, he writes: “It’s mostly true. There are definitely anomalies … But it remains the case that most active managers fail to beat the market. Even when investors can know for sure prices are wrong, these prices can still stay wrong, or even get more wrong. This should rightly scare investors who think they are smart and want to exploit apparent mispricing. It’s possible to make money, but it’s not easy.” Thaler then concludes: “Investors who accept the EMH gospel and invest in low-cost index funds cannot be faulted for that choice.”

Second, regarding the “price is right” component of the EMH, Thaler has a much lower opinion. A basic hypothesis of behavioral finance is that, due to behavioral biases, markets make persistent mistakes in pricing securities. An example of a persistent mistake is that the market underreacts to news. In other words, both good and bad news is only slowly incorporated into prices.

A Business Built On Others’ Errors
Fuller and Thaler Asset Management was formed in 1993 to exploit such errors. In his book, Thaler states: “The fact that the firm is still in business suggests that we have either been successful at using behavioral finance to beat the market, or have been lucky, or both.” We can test that statement.

Fuller and Thaler originally offered two publicly available mutual funds based on behavioral theories: Undiscovered Managers Behavioral Growth Fund and Undiscovered Managers Behavioral Value Fund. To test Thaler’s assertion, we will compare the performance of these funds to the performance of the Dimensional Fund Advisors (DFA) U.S. Small Cap Fund and U.S. Small Cap Value Fund, respectively. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)

The DFA funds are managed based on the belief that markets are efficient, so stock-selection and market-timing efforts are eschewed. Thus, we have a real live test of the behavioral theory versus the efficiency of the markets. Note that J.P. Morgan acquired the behavioral-finance funds in January 2004. However, Fuller and Thaler continued on as subadvisors.

Behavioral Finance Vs. DFA
Morningstar classifies the Undiscovered Managers Behavioral Value fund (UBVLX) as a small value fund. For the 15-year period ending June 26, the fund returned 11.32 percent. For the same period, the US Small Cap Value I fund from DFA (DFSVX) returned 11.68 percent, outperforming the behavioral fund by 0.36 percentage points a year. Strike one.

Unfortunately, the news only gets worse for Thaler, because the Undiscovered Managers Behavioral Growth Fund closed at the end October 2012. It’s rare—if unheard of—for a fund to close when it’s producing great returns.

While I don’t have data on the returns of the behavioral growth fund through its close, I did write about it in early 2010. I found that for the 10-year period from 2000 through 2009, the Undiscovered Managers Behavioral Growth Fund returned –2.0 percent per year. That’s compared with the 5.7 percent per year return for the DFA US Small Cap Fund (DFSTX) during the same period, an underperformance for the behavioral fund of 7.7 percentage points a year. Strike two.In my research for this article, I discovered that Richard Fuller, founder of Fuller and Thaler, is manager for the AllianzGI Behavioral Advantage Large Cap Fund (A shares: AZFAX). Morningstar classifies the fund as a large blend fund. Thus, we’ll compare its performance to the DFA US Large Company I fund (DFUSX). Morningstar reports that for the three-year period ending June 26 (the fund’s inception date is late in 2011), AZFAX returned 18.76 percent. For the same period, DFUSX returned 19.16 percent, outperforming AZFAX by 0.4 percentage points a year. Strike three.

But Wait!

Well, perhaps not exactly. In an effort to be as fair as possible, I also checked the fund’s performance beginning with the start of 2012, because Morningstar does provide that information.

Using that date, a dollar invested in AZFAX had increased to $1.87 by June 26. A dollar invested in DFUSX would have increased to just $1.80. That’s an outperformance of about 1 percent a year. Unfortunately, since the fund has underperformed over the last three years, that’s not much of an endorsement, especially in light of the underperformance of the other two funds.

Based upon the real-world results of the three funds run by Fuller and Thaler, it’s clear that investors in their funds would have been better served by heeding Thaler’s own warning: While it’s possible to beat the markets, it’s not easy.

And while the EMH clearly is not a perfect model of how markets set prices, the evidence is overwhelming that investors—even those who believe that the behavioralists are right about the presence of mispricings—are better served by acting as if it were a perfect model.


Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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