Behavioral Law and Disorder

Mutual Fund Perfection

It’s may come as a surprise to you that the mutual fund industry, at least in the United States, is a shining record of fiduciary duty. It’s a fact that not once in twenty-five years did a shareholder in one of these funds manage to convince a court that their money has, in any way whatsoever, been mismanaged. This is despite a raft of allegations, originally stemming from the investigations of the ever-vigilant, if nocturnally over-enthusiastic, ex-Attorney General of New York, Elliot Spitzer, that many of the advisors running these funds had deliberately siphoned profits from long-term individual shareholders to institutional clients.

However, a recent judicial decision moves the goalposts – it’s no longer theoretically impossible for a private shareholder to successfully sue a mutual fund. No, now it’s actually impossible. The reason for this is grounded in an economic theory of the marketplace that is dying everywhere else: the idea that markets are perfect. It’s time for a little behavioural law and order.

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Do Behavioral Funds Work?

No. Maybe.

For all the impressive research on behavioural finance the acid test is ultimately whether it can yield better returns for investors. A few intrepid souls have set out to discover whether there’s any evidence that investing along behavioural lines can produce such returns and have re-emerged from the mutual fund jungle, somewhat battered and worse for wear, with the broad answer of, err, “No, it doesn’t”.

Of course, there’s a bit of a puzzle behind the research because the concept “behavioural investing” is somewhat amorphous. It would be unsurprising, given the parasitic mutational qualities of the financial sector, if the rise of behavioural finance didn’t attract managers who see it as the next destination of hot money. It’s enough to make your head spin: behavioural finance itself could be the next behavioural finance anomaly.

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Survivorship Bias in Magical Mutual Funds

The Magical Inflation of Mutual Fund Returns

Despite years and years of data showing that, on average, actively managed funds underperform their passive brethren by around the amount charged in fees – a point William Sharpe demonstrated using the most basic math back in 1991 (The Arithmetic of Active Management) – the darned things won’t lie down and be slain. Worse still, they use their excess fees to dream up smart new ways of improving their apparent returns.

Perhaps the cleverest and simplest method is to magically make the worst performers disappear from the record, a clever trick I wish I could perform with my portfolio. However, just like the investors in those disappeared funds, I’m stuck with my returns while the funds benefit through survivorship bias.

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