By LARRY SWEDROE
The basic hypothesis of behavioural finance — the study of human behaviour and how that behaviour leads to investment errors, including the mispricing of assets — is that due to behavioural biases, investors/markets make persistent mistakes in pricing securities. An example of a persistent mistake is that investors under-react to news—both good and bad news are only slowly incorporated into prices, resulting in the momentum anomaly. My book Investment Mistakes Even Smart Investors Make and How to Avoid Them covers 77 mistakes, most of which are related to behavioural errors (others are simply due to lack of knowledge).
An interesting question is whether better-trained professional fund managers — typically considered “smart” money that is able to exploit the pricing mistakes of retail investors — also make behavioural mistakes. While they may be better trained, they are still human and perhaps still subject to the same type of behavioural errors made by individuals.
Meharn Azimi contributes to the literature on this question with his October 2019 study, Are Professional Investors Prone to Behavioral Biases? Evidence from Mutual Fund Managers. To determine if mutual fund managers were making behavioural errors, Azimi examined mutual funds semiannual reports, known as N-CSR(S), that are publicly available on the EDGAR website, in which some fund managers discuss their outlook on the stock market. His data sample covered the period 2006 through 2018 and included over 40,000 fund observations. About 25 percent of those discussed their market outlook in their reports.
Based on Azimi’s reading of the discussions, he created a measure of a manager’s belief in expected returns. He called the measure “Belief.” In order to quantify expectations, he classified Belief into three categories: bullish, neutral, bearish. Bullish views were those in which managers are optimistic about the market or think that the market is undervalued. Neutral views were generally characterised as fairly valued stocks or modest/moderate expected returns. Bearish views were expressed as expecting high volatility in the stock market or believing that stocks are overvalued.
Here is a summary of his findings:
Fund managers’ investments correspond to their market outlook. A change in Belief from neutral to bullish leads to an increase in the beta of the fund and a decrease in their cash positions (statistically significant at the one per cent confidence level).
Belief is more strongly related to equity holdings and the beta of equity portfolios in funds with high turnover (significant at the five per cent confidence level) and in smaller funds (statistically significant at the ten per cent confidence level).
Just as individual investors extrapolate past returns and prices into the future, a fund manager’s past return positively predicts his Belief (for example, strong past fund returns predict future bullish outlook). Past return is related to both bearish and bullish views of the market. The finding was significant at the five per cent confidence level.
While funds with higher market expected return take more risk (as evident in high portfolio betas and greater equity holdings), investors don’t benefit because there is a negative correlation between Belief and future fund alpha — the more bullish the manager, the more negative the alpha tended to be. The finding is statistically significant at the five percent confidence level, though it is statistically significant at the one percent level for funds with low flow and insignificant for funds with positive flow. The estimated negative relation between Belief and future alpha is 60 per cent, and 80 per cent larger in a subsample of funds that have low past fund flow and funds that have high expense ratio, respectively.
Prior investment experience affects fund managers’ market outlook (as has been found with individual investors). Specifically, funds that have at least one manager who experienced the dot-com crash tend to have lower return expectations. However, the observed effect exists only for funds with a negative market outlook, not a bullish one.
Managers are more affected by their best-performing funds as opposed to their worst-performing funds.
Azimi concluded that his findings “suggest that professional investors suffer from behavioural biases, that their market outlook affects their risk taking and asset allocation, and that fund managers’ optimism is detrimental to fund investors.”
Azimi’s findings that behavioural biases exist in professional money managers as well as individuals is consistent with the findings of the 2018 study Stock Repurchasing Bias of Mutual Funds. The authors, Mengqiao Du, Alexandra Niessen-Ruenzi and Terrance Odean, examined whether past experiences (positive or negative) a fund manager had with a particular stock are predictive for the stock being repurchased. They hypothesised that “selling a stock for a gain is associated with positive emotions such as pride and happiness, while selling a stock for a loss is associated with negative emotions such as regret and disappointment. In an effort to repeat the positive emotional experience and avoid the negative one, mutual fund managers may be more prone to repurchase a stock that they sold for a gain (i.e., a past ‘winner’), while they may be less prone to repurchase a stock that they sold for a loss (i.e. a past ‘loser’).”
The study covered U.S. mutual funds over the period 1980 to 2014. The following is a summary of their findings:
Controlling for fund, stock and time fixed effects, the probability of a stock being repurchased by a mutual fund is, on average, around 17 percent higher if it was previously sold for a gain rather than for a loss.
The effect is less pronounced if the stock price increased after the sale of the stock, which may cause regret and a negative feeling that the stock was sold in the first place.
Mutual fund managers are more likely to repurchase past winner stocks if their prices decreased after they were completely sold.
Fund managers changing jobs, and now working at a different fund, still prefer to repurchase stocks that they sold for a gain at the fund they managed before.
Consistent with previous literature on the negative impact of group thinking on fund performance, team-managed funds exhibit a stronger repurchasing bias (more heads are not better than one in this case). Previous literature has also shown that a substantial fraction of mutual fund managers are subject to the well-documented disposition effect, realising gains more readily than losses.
A stock’s likelihood of being repurchased does not increase even further the higher the gain from the previous sale, while its likelihood of being repurchased does decrease even further the higher the losses incurred when selling the stock before. The asymmetric impact of the magnitude of losses and gains on the repurchasing probability may be due to the well-documented behaviour known as “loss aversion”.
The positive emotion-driven behaviour is associated with lower fund performance: Repurchased winners underperform repurchased losers by around 5 percentage points per year after the repurchase. The Carhart four-factor (beta, size, value and momentum) alpha of the repurchased winner portfolio is more than 4 percentage points lower than that of the repurchased loser portfolio.
Repurchased stocks’ prices increase between the time they have been sold and repurchased, and stock prices of repurchased winners increase even more than those of repurchased losers, suggesting that mutual funds would have benefited from just holding these stocks, especially winner stocks that they repurchase later. These results suggest that repurchasing bias of mutual funds is not due to superior information about past winner stocks.
These findings, which were statistically significant at high confidence levels, led the authors to conclude that “investors should be aware that mutual fund managers’ repurchasing decisions can be biased and eventually may hurt their performance”.
The findings that professional fund managers make many of the same behavioural errors that individuals make should not come as much of a surprise. After all, fund managers are human too.
The body of evidence makes clear that institutional investors are subject to at least some of the behavioural errors attributed to individual investors. Among these biases are home bias and overconfidence. These findings provide you with yet another reason to avoid the use of actively managed funds. Passively managed funds (such as index funds) by definition are not subject to these behaviours.
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of 17 books on investing, including Think, Act, and Invest Like Warren Buffett.
If you’re interested in reading more of his work, here are his other most recent articles for TEBI: