“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.”
—Economics professors Dwight Lee and James Verbrugge, University of Georgia
Richard Thaler, a professor of behavioral science and economics at the University of Chicago, is a recognized leader in the field of behavioral finance. The basic hypothesis of behavioral finance is that, due to behavioral biases, markets make persistent mistakes in the pricing of securities. An example of a persistent mistake is that the market underreacts to news—both good and bad news is only slowly incorporated into prices.
Thaler is also one of the founders of California-based Fuller & Thaler Asset Management. On its website, the firm states: “Our bottom-up investment approach exploits insights from behavioral finance. Under certain conditions behavioral biases cause market participants to misprocess information in the financial markets. We use every tool available to us to identify the stocks where these biases lead to mispriced securities. We believe that our process is repeatable and sustainable, and that we provide an uncorrelated source of alpha to our clients.”
Like we mentioned previously, an often-cited example of a persistently occurring mistake is that the market underreacts to financial and other news. Fuller & Thaler Asset Management was formed to exploit such errors.
Testing A Theory
Fuller & Thaler offered two funds informed by the firm’s behavioral approach: the Undiscovered Managers Behavioral Growth Fund and the Undiscovered Managers Behavioral Value Fund. To test their theories, we will compare the performance of these two funds to the performance of the U.S. Small Cap Fund and the U.S. Small Cap Value Fund, respectively, from Dimensional Fund Advisors (DFA). (Note that JPMorgan Chase & Co. acquired the Fuller & Thaler funds in January 2004. However, Fuller & Thaler continued as subadvisors.)
The two 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 market. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)
Using data from Morningstar, we find that for the 15-year period ending April 20, 2015, the Undiscovered Managers Behavioral Value Fund (UBVLX), which Morningstar classifies as a small value fund, returned 11.59 percent per year. The DFA U.S. Small Cap Value Fund (DFSVX) returned 11.70 percent per year.
Unfortunately, we don’t have data for the Undiscovered Managers Behavioral Growth Fund. The reason is that, as of October 2012, the fund was closed. It’s rare, if not unheard of, for a fund to close when it has produced good returns.
While I don’t have the returns of the behavioral growth fund through its close, I did write about the fund in early 2010. I found that for the 10-year period from 2000 through 2009, the behavioral growth fund returned -2.0 percent per year. This is compared with the 5.7 percent per year return of DFA’s U.S. Small Cap Fund (DFSTX). The Undiscovered Managers Behavioral Growth Fund even underperformed the S&P 500 Index by 1 percentage point per year.
So far, there doesn’t seem to be much, if any, evidence for their ability to exploit in a systematic way the behavioral mispricings that Fuller & Thaler claimed exist in the market.
LSV Asset Management (LSV) was formed in 1994 by professors Josef Lakonishok (formerly of the 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. Their research is the foundation for LSV’s investment strategy.
The basic premise of their approach is that superior long-term results can be achieved by systematically exploiting the judgmental biases and behavioral weaknesses that influence the decisions of many investors.
These include the tendency to extrapolate the past too far into the future, the tendency to wrongly equate a good company with a good investment irrespective of price, the tendency to ignore statistical evidence, and the tendency to develop a “mindset” about a company. In other words, they believe that the market persistently misprices securities and that the pricing mistakes can be exploited.
While LSV is basically an institutional money manager, it also runs mutual funds. Morningstar data shows that as of April 20, 2015, the LSV Value Equity Fund (LSVEX), a large value fund, had a 15-year return of 9.20 percent per year. The return for the DFA U.S. Large Cap Value Fund (DFLVX) was 8.84 percent per year.
So far, so good. But LSV also runs a second fund, the Conservative Value Equity Fund (LSVVX), for which we have more than just a few years of data. For the eight-year period from April 2007 through March 2015, the fund returned 4.88 percent per year.
In the same period, DFLVX returned 6.12 percent a year. So, while LSVEX outperformed DFLVX by 0.36 percentage points a year, LSVVX underperformed DFLVX by 1.24 percentage points a year.
Once again, we fail to see any evidence that fundamental research (in this case, research based on behavioral finance findings) leading to individual stock selection provides an advantage over a systematic approach to value investing.
Behavioral Finance: Do Disciples Benefit?
Prithviraj Banerjee, Vaneesha Boney and Colbrin Wright, authors of the study “Behavioral Finance: Are the Disciples Profiting from the Doctrine?”, provide us with additional evidence on the ability of behavioral funds to exploit mispricings.
The authors of the study, which was published in the Winter 2008 issue of the Journal of Investing, examined the results from 16 self-proclaimed or media-identified behavioral mutual funds. Behavioral mutual funds are funds that practice some form of behavioral finance in their investment strategies. The following is a summary of their findings:
- Behavioral funds are successfully attracting investment dollars at a significantly greater rate than index and matched actively managed, nonbehavioral funds. Investors apparently believe that pricing errors are persistently exploitable.
- While the funds do outperform S&P 500 index funds, the explanation for their outperformance is that they load very heavily on the high minus low (HmL) factor, also known as the value factor. Said another way, they have significant exposure to value stocks. Thus, after adjusting for risk, they don’t earn abnormal returns.
- Behavioral mutual funds are tantamount to value investing and not much more.
There’s Smoke, But No Fire
While behavioral finance has gained substantial attention in academia, and seems to be gaining greater acceptance among practitioners, there doesn’t seem to be any evidence to support its raison d’etre; namely, that anomalies can be identified and exploited on a persistent basis.
Even if anomalies do exist, there remain two simple and plausible explanations for the findings of the aforementioned study. The first is that strategies have no costs, but implementing them does. A strategy might appear to work well on paper, but the costs of implementation can often 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 or reduce the size of the pricing error.
Based on the performance of funds designed to exploit behavioral mistakes—both the ones that we examined and those included in the study we reviewed—there doesn’t seem to be any evidence in support of the behavioralist theory as an implementable strategy.
The one exception involves evidence that momentum can be used to generate a premium. In fact, the DFA funds discussed above incorporate momentum screens into their fund construction rules. The moral of this tale is that those who seek to exploit market anomalies often find that the markets are tyrannical in their efficiency.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.