Behavioral funds are gaining increasing interest among the investors, academicians and in the overall fund market. The underlying principle of behavioral funds opens up significant research and analysis opportunities, allowing a wide variety of investment strategies to be used to launch a behavioral fund. This article explains how behavioral funds work, their underlying concepts, historical performance and associated risks.
The Irrational Investor
Behavioral finance is the study of human behavior, practice, and tendencies related to finance, economics, and investment decision-making. Different people act differently with money. Based upon instant investor sentiment and possibly irrational behavior, the price of a financial instrument often moves away from its intrinsic fair value. This leads to price anomalies, which create sufficient opportunities to be encashed upon by active trading. (Related: How Cognitive Bias Affects Your Business)
How Do Behavioral Funds Work?
Behavioral funds attempt to benefit from the opportunities arising from such price anomalies, which are based on investor sentiment, decision-making and irrational behavior. The investment strategy for such behavioral funds may seek out the following:
- Identify irrational biases in the market, which may exaggerate the impact of negative news beating the stock prices to much deeper levels (for low-cost buying opportunities), or overplay the impact of positive news by pumping the stock prices to higher levels (for high-cost short selling opportunities).
- Identify stocks temporarily having lower/higher than expected indicators (like price-to-earnings ratio). Comparing these against other fundamentals, like a company’s credit risk and valuations, may indicate better investment picks in a timely manner. (Related: How To Use The P/E Ratio And PEG To Tell A Stock's Future)
- Identify stocks that may have temporarily underperformed relative to the overall market based on irrational exuberance, but continue to have strong fundamentals (Related: What Are A Stock's "Fundamentals"?)
- Identify stocks based on other potential developments leading to profitable opportunities, like from an expected share buy-back or stock split. (Related: Impact of Share Repurchases)
Performance of Behavioral Funds
Study and results presented in the research paper Did Behavioral Mutual Funds Exploit Market Inefficiencies During or After the Financial Crisis? indicate that the funds applying principles of behavioral finance as their underlying investment strategy fail to outperform the market. The author studies monthly market returns for 22 different behavioral funds over a period of January 2007 to March 2013. This period of study includes the global recession period of 2009, as well as the growth period that followed. Returns are compared against those from benchmark indices and passively managed index funds.
The worst performing behavioral fund generated average monthly return of -0.86%, and the best generated +0.80%. The average of all 22 funds under study had a monthly average return of 0.33%. During the same period, S&P 500 returned 0.27%, while the overall US market returned 0.5%. In essence, the average behavioral fund did not outperform the market.
A similar study "Are Behavioral Finance Equity Funds a Superior Investment?" cited by CBSnews shows similar results. The study was performed on 59 different US and global behavioral funds during the 21-year long period from 1990 to 2010. There was no evidence of outperformance. The results cite that raw returns of “U.S. behavioral funds outperformed during bull markets but underperformed in bear markets,” and “In Europe, fund performance was statistically negative even in bull markets.” But when the raw returns are risk adjusted, the outperformance during bull markets vanishes, and the underperformance during bear markets continues.
Challenges With Behavioral Funds
The underlying principle of behavioral funds goes against the much established efficient market hypothesis (EMH). EMH is the foundation of index funds and index-based exchange traded funds, and these instruments have emerged as among the most efficient forms of investment.
EMH does not hold true in complete sense, as stocks do demonstrate undervalued and overvalued scenarios at times. The challenge with the behavioral funds investment strategy is that anomalies underlying such irrational behavioral are difficult to model, predict, and follow consistently. It includes the underlying assumption that anomalies will keep occurring and fund management will encash on them in a timely manner. In practice, this may be difficult to realize, and that is the reason that historical returns don’t show any significant performance. While select behavioral funds do outperform the market (as with the cited +0.80% returns), the majority of them fail. The average return of the overall behavioral fund basket lies below the market returns.
The Bottom Line
The behavioral funds concept has existed for last few decades. It has managed to attract a good level of interest at the academic and industry levels, bringing in a significant portion of investment money from investors. The wide variety of behavioral concepts that can be explored and implemented as fund strategies is limitless, which has allowed multiple funds to be launched with attractive marketing claims. However, realistic studies on historical data put a question mark on their performance. Willing investors may explore this stream of fund investments to add another level of diversification to their portfolios.