Swedroe: Behavioral Funds Disappoint

October 26, 2015

Behavioral finance combines the study of human behavior and cognitive psychology with traditional economic and financial theory to explain why people make irrational decisions that can lead to investment mistakes, including the mispricing of assets (which are called anomalies).

The field has gained an increasing amount of attention in academia over the past 15 years or so as pricing anomalies continue to be discovered, providing us with useful insights regarding the errors of judgment made by investors (errors that can, of course, penalize results). This is one reason Princeton psychology professor Daniel Kahneman was awarded the 2002 Nobel Prize in economics.

More and more, mutual funds are marketing themselves as behavioral funds that try to exploit anomalies. These pricing anomalies present a problem for believers in the efficient markets hypothesis. However, the real question for investors is not whether the market persistently makes pricing errors; rather, the true question is: Are the anomalies exploitable after taking into account real-world costs?

Evaluating Behavioral Funds

To help answer it, Nikolaos Philippas authored the paper “Did Behavioral Mutual Funds Exploit Market Inefficiencies During or After the Financial Crisis?”, which was published in an early 2014 issue of Multinational Finance Journal.

In his study, which covered the period January 2007 through March 2013, Philippas examined the performance of 22 U.S. behavioral mutual funds (mutual funds that employ investment strategies based on behavioral finance principles). Among his sample were funds from some of the most recognizable firms on Wall Street and the biggest names in the field:

  • Five funds from JPMorgan.
  • Several funds run by Fuller and Thaler Asset Management. Firm principal Richard Thaler is a distinguished service professor of behavioral science and economics at the University of Chicago’s Booth School of Business.
  • Several funds run by LSV Asset Management. The firm was formed in 1994 by professors Josef Lakonishok (University of Illinois at Urbana-Champaign); Andrei Shleifer (Harvard University); and Robert Vishny (University of Chicago). Together, they have published more than 200 academic papers on investing and the field of behavioral finance.
  • Two DWS funds run by Deutsche Asset Management.
  • Several funds run by Dreman Value Management. Founder David Dreman is on the board of directors of the Institute of Behavioral Finance, publisher of the Journal of Behavioral Finance.

Philippas hypothesized that the 2008-2009 financial crisis would be an ideal time to test behavioral theories because such periods can lead to herding behaviors, which can in turn lead to bubbles and crashes.

Based on the conjecture that persistent mispricings during the crisis period—caused by “limits to arbitrage”—would make it more difficult for institutional investors to exploit mispricings relative to opportunistic mispricings arising from the behavioral biases exhibited by investors in the aftermath of the crisis, Philippas conducted a subperiod analysis that distinguished between the crisis period (January 2007 to December 2009) and the post-crisis period (January 2010 to March 2013).

He then used multiple measures and multiple factors (beta, size, value and momentum) to determine whether the behavioral funds in question were generating alpha.


Following is a summary of his findings:

  • Results from both the full sample and subperiod show that behavioral mutual funds exhibited poor performance, both during the recent financial crisis as well as in its aftermath, rejecting the hypothesis that the crisis period would provide an ideal environment for behavioral funds strategies to demonstrate profitability by exploiting market inefficiencies and investors' behavioral biases.
  • The managers of behavioral funds neither outperformed their benchmarks nor exhibited market-timing ability.
  • There wasn’t a single fund that yielded an economically or statistically significant CAPM alpha (often referred to as Jensen’s alpha) in the full sample period. However, there were eight funds that produced significantly negative alphas. Very similar results were found in the subperiod analysis. In fact, in the period corresponding with the aftermath of the crisis, when these funds could potentially exploit investors’ biases, most of them yielded negative market-adjusted returns. Nine of the 22 funds had negative alphas that were statistically significant.
  • Even when using self-declared benchmarks, there was no evidence of significant outperformance.
  • Results were similar when using the four Carhart factors (beta, size, value and momentum). The majority of funds produced negative risk-adjusted performance. What’s more, the results were economically and statistically significant for a large number of them. These findings hold true in the full sample period as well as in the subperiods. There wasn’t a single fund that produced a significant positive Carhart alpha.
  • Economically and statistically significant underperformance was reported for a number of funds relative to the market and their benchmark indexes. This evidence remained intact even when looking at the subperiods.
  • There was no evidence that behavioral funds follow any particular investment style, such as size, value or momentum strategies. This was surprising, because behavioral strategies are often viewed as contrarian, or value, strategies. And while some funds had significant loadings on the size and momentum factors, they were positive for some funds and negative for others. Thus, it cannot be argued that these funds systematically implemented size or momentum strategies.
  • None of the funds exhibited superior market-timing skill. However, four funds exhibited negative market-timing ability. The subperiod results were similar.
  • There was a negative correlation between a fund’s performance and its size.

The authors reached the following conclusion: “The results indicate that there is no evidence of outperformance of behavioral funds versus the market return and respective benchmark indices on a risk-adjusted basis. To the contrary, we find that some funds significantly underperform their benchmarks both in economic and in statistical terms.”


While the principles of behavioral finance appear to be gaining greater acceptance among investors seeking alpha, there does not seem to be any evidence to support the belief that anomalies can be identified and capitalized upon on a consistent basis. Even if anomalies do exist, there are two simple and plausible explanations for the findings of the study.

The first is that, while a strategy has no costs, implementing a strategy does. Thus, a strategy may appear to work on paper, but the costs of implementation could exceed the size of the pricing errors. The second is that, once an anomaly is discovered and attempts are made to exploit it, the very act of doing so will serve to eliminate/reduce the size of the pricing error.

Investors who seek to exploit market anomalies almost inevitably find that the markets are tyrannical in their efficiency. Economics professors Dwight Lee and James Verbrugge of the University of Georgia put it this way: “The efficient markets theory is practically alone among theories in that it becomes more powerful when people discover serious inconsistencies between it and the real world. If a clear efficient market anomaly is discovered, the behavior (or lack of behavior) that gives rise to it will tend to be eliminated by competition among investors for higher returns.”

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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