More and more mutual funds are marketing themselves as behavioral funds that try to exploit such anomalies. Pricing anomalies present a problem for those that believe in the Efficient Market Hypothesis. However, the real question for investors isn't whether the market persistently makes pricing errors. Instead, the real question is: Are the anomalies exploitable after taking into account real world costs?
The authors of the study "Behavioral Finance: An Analysis of the Performance of Behavioral Funds" examined the results of 31 funds that claim to apply behavioral finance in their portfolio strategy. Collectively, they managed $16 billion. The study included the Fuller & Thaler fund family, JPMorgan's Intrepid funds, the Bank Degroof funds, LSV funds, and LGT funds. They analyzed their performance from inception (early 90s in some cases) until August 18, 2009 and found:
- There was no clear evidence of outperformance of behavioral funds against their respective indexes.
- Over a five-year horizon, only 47 percent of these funds beat their benchmarks.
- Among behavioral funds, there was a very low correlation between fund diversification and its ability to beat the benchmark -- concentrating assets didn't help.
- On average, behavioral funds weren't particularly good in beating the market during bear markets -- in two out of three cases, the performance was poorer than their benchmark.
While behavioral finance seems to be gaining greater acceptance among investors, there doesn't seem to be any evidence to support the belief that anomalies can be identified and exploited on a consistent basis. Even if there are anomalies, there are two simple and plausible explanations for the findings of the study:
- Strategies have no costs, but implementing them does. Thus, a strategy may appear to work on paper, but the costs of implementation can exceed the size of the pricing errors.
- Once an anomaly is discovered, the very act of exploiting it will serve to eliminate/reduce the size of the pricing error.
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