Archive for Private Investors

Men versus Women; The Impact of Gender on Differences in Investment Style and Results

Posted in Behavioral Finance, Financial Markets, Manager Selection with tags , , , , , , , , , , on March 12, 2009 by evd101

By Erik L. van Dijk

In our last two blog posts we analyzed how private investors take their decisions. With our without the help of financial planners, the non-professionals seem to struggle in the financial market place. Before concentrating ourselves on the institutional side of the industry in later blog entries, we would like to ask the question: but what about gender? When looking at the TV, or reading a newspaper, it seems clear that the financial world is (still?) mainly male-dominated. This is especially true when it comes to the main executive and ‘content’-related positions in the industry. In marketing and sales things are slightly different, for obvious reasons: when the industry is male-dominated, and not just that, but even dominated by alpha males that exert some macho characteristics, then don’t be surprised that it pays off to overweight the percentage of good-looking, eloquent, nicely-dressed and -heeled women in your marketing/sales staff.

But is this gender pattern in line with investment qualities? During the last 10-15 years there has been quite a bit of behavioral research into this question. And now, with the group of Wall Street, London or elsewhere-based crooks (be they big bankers or frauds) that have or should apologize for the Credit Crisis being male-only, it is interesting to summarize the results. A remarkable, but clear pattern evolves:

i) Gender and Investment Confidence

It will not come as a big surprise that all research seems to indicate that one important difference between the sexes is that men tend to believe that they understand investments, whereas women have less difficulty explaining that they are not so sure about their abilities. And in and of itself this lower ego is not a wrong thing: investment analysis and portfolio management is a complicated thing. A far larger number of disasters were the result from overconfidence than from lack of confidence. The result of this difference in confidence is first and foremost that less women trust themselves to start investing (as amateur) or even consider a career in investments. But what remains to be seen is if the confidence differential translates into quality differences between those men and women that start to invest.

ii) From confidence differential to style differential: women care more about the details

The lower confidence levels in women translate into an approach in which women want to know far more about their potential investment than men. Men ‘think’ that they understand things much quicker than women do. Result: women will dig deeper when it comes to the information-gathering phase before deciding if they buy/sell an investment.

iii) Women: the careful investors. From less confidence and more detail to lower-risk strategies

And even when studying a larger information set, women don’t get rid of their initial negative confidence level gap. They remain prudent and translate knowing more into a larger interest in investments in asset classes with lower risk. I.e. fixed income securities, real estate et cetera. Men like to go for higher beta (more systematic risk) and higher volatility securities. This implies that – if we will find a return differential between men and women in favor of portfolios created by men – we will have to make sure that portfolio returns are corrected for differences in risk, before making our final judgment.

iv) How the lower ego of women translates into a larger willingness to incorporate mutual funds in

the portfolio

When your personal SWOT indicates – after careful revision of the available data – that you don’t know enough, then it is far better to outsource the decision to a professional with proven track record than to gamble. Women do therefore use a larger percentage mutual funds than men do. Sometimes up to 40 percent larger allocations to mutual funds. This does translate into a larger diversification of women portfolios and it adds to the risk differential between female and male portfolios, even when looking within a specific asset class.

v) Style drift: women are more style consistent

One of the problems with investing is that you will go through periods of success and lesser periods. When doing so, investors will also be exposed to external information from news media, so-called experts et cetera indicating where the real profits were. This will create an innate tendency to shift your style bets away from the original plans into new territory that might seem to generate better results. Men are far more sensitive to this style drift than women are. To some extent this is caused by the fact that women in general won’t embark so quickly on a new path. They are less afraid to miss out on that so-called ‘unique opportunity’. They have a longer-term investment approach and understand that a new chance will always follow.

vi) Men are better for their brokers: excess trading

The overconfidence of men and the eagerness to follow the quick buck leads them into strategies that involve a larger amount of trading. Studies seem to indicate that the average annual turnover of male portfolios is some 25-50 percent higher than that of female portfolios. This larger trading activity in male portfolios is the result of overconfidence (‘I understand the market and feel that this is the right time for a timing-related switch!’) and to another extend to the shorter-term focus of men. It will obviously lead to higher trading costs, that will eat away part of the gross return on the male portfolio. Note that the male portfolio should – based on what we found so far – outperform the female portfolio on a gross basis, because of the excess risk taken. If you have a larger tilt towards higher risk instruments, you should earn a higher gross return. And net return as well, unless the trading wasn’t smart in the first place. Interestingly, some studies seem to indicate that this was indeed the case: the net results of the male and female portfolios would have been higher had they refrained from intra-year trading and concentrate on an annual buy-and-hold strategy instead!

vii) The Return Analysis, who wins: men or women?

One of the most important studies analyzing the return differential on female and male portfolios was the 2001 Barber & Odean paper Boys will be boys: Gender, Overconfidence and Common Stock Investment as published in the Quarterly Journal of Economics. Barber and Odean were also (together with Heath) writers of the paper that we used in yesterday’s blog on ‘Good Reasons’ investing. It is quite likely that women – fed by a larger information base with more details – use more complicated decision models that are to a lesser extent prone to the ‘good reasons’ fallacy. And indeed, studying the investment behavior of more than 35,000 households over the 1991-1997 period the authors conclude that single women score portfolio returns on a risk-adjusted basis that exceed those of single men by 3.0% annually. In marriage couples that decided to have men and women invest separately the differnence is still there, but to a lesser extent: in that case the women outperform by 1.4%. And this is not a pure US result. A 2005 study in the UK corroborated these findings. Actually, UK blokes are relatively lousier investors than their US counterparts were, or, UK women were better than US ones, or a combination of both. But more research is needed, since the Barber-Odean study was more rigorous and robust than the UK one.

Another study by Kuenzi and Riessen (University of Cologne, Germany, 2006) came to the conclusion that the differential net return did not exist when looking at mutual funds that were either led by a woman investor as leading portfolio manager or a man. In other words: the overconfidence of men leads to disasters when it is not based on some kind of background knowledge. Male amateurs seem to forget that they are just that: amateurs. But when taking a closer look at the Kuenzi-Riessen paper the result is still surprising. First, we should not forget that there are far more mutual funds led by men than there are by women, and the funds that men manage are much bigger too. As if there was an innate tendency in the professional community to mistrust women that didn’t want to focus on selling and looking good, but on fund returns instead. Now, Kuenzi and Riessen show that on a gross basis male mutual funds do indeed outperform. However, the outperformance was to a large extent directly related to the fact that they take more risks. So part of the excess return was eaten away after a proper risk-adjustment. There was still a bit of outperformance left though, but that gross outperformance was consecutively eaten away by excess trading. Final result therefore: equal net returns, but the women got there with excellent style consistency. Knowing that style consistency is in and of itself also important in asset management (because you should always assume that you are not running the whole portfolio of the client, so that if you don’t stick to your job his/her overall portfolio risk-return profile might start to be hurt), the conclusion should again be that – if anything – women win.

viii) Give women more space and investment responsibilities

So women should feel a bit more confident about their investment qualities (as long as they don’t become overconfident!), and the men that dominate the investment community or their married amateur counterparts that still believe that they are best-equipped to do the finances at home should give women more credit for their hidden investment qualities and give them more space.

In a slightly different setting, Harvard professor Boris Groysberg corroborates these findings. In the August 2008 Harvard Business Review he gives a nice interview to reporter Martha Lagace, explaining that based on his research ‘star’ women (be they financial analysts, lawyers, investment managers, accountants, investment bankers et cetera) are more successful than men when changing their job. The ‘star’ women that are hired by a new employer who wants to pay more or offer other fringe benefits for the new divas are far less disappointed than employers who hire male ‘stars’ from another company. Groysberg explains that there are two reasons for this:

a) Portable Relationships

Women are good in having both internal and external relationships and this phenomenon is part of the same process that made them look for more details when it comes to taking investment decisions (see above). Never wrong to know more (be it about things or be it people). Result: they can easily adjust to new circumstances, with their external network helping them cope with it. Men on the other hand are more inward-looking (either alone or with their smaller group of buddies), and do therefore struggle when switching to a new, unknown situation.

b) Smarter Evaluation

Women use ‘multi-factor’ approaches in which they probably are not totally aware of the exact weights of factors in that decision process (they are not necessarily more quantitative than men, on the contrary!), but they know damn well that it is wrong in complicated situations to use an oversimplified decision procedure. In other words: they are less senstive to Barber, Heath and Odean’s ‘Good Reason’s Fallacy’ that we explained in yesterday’s entry. This implies that women take better decisions about when to switch jobs and to what employer to go.

ix) It was a man’s world. Will James Brown’s song become past tense in the credit crisis and the years ahead of us?

I think that it is impossible to believe that the gender divide will continue in its current form. Especially so after the credit crisis in which the male species played such a dominating role. Coming from a family of strong women, where men were never inclined to think that they were the dominant species and blessed with a sister that is indeed a savvy, smart investor who – based on qualitative reasoning – was always capable of challenging my ‘quant’-based work and making sure that I didn’t forget to incorporate qualitative factors in our decision processes at Lodewijk Meijer, I don’t find this shocking. However, I cannot exclude the rise of some kind of countermovement that wants to maintain the existing glass ceiling that is hindering upwardly mobile women in society in general and in investing in particular.

On a global scale the sign of times is that women will  become more important in our industry and based on what we just mentioned, that is a good thing.  Last month, the Financial Times published a nice article about female Japanese investors. Contrary to what many Western outsiders might think, women in this Asian country do already play a far stronger role when it comes to managing the household budget and savings than their western counterparts do. Actually, Kyoto professor Noriko Hama believes that Japanese women have played a significant role in recent arbitrage trends in the fixed income and currency markets. During the last 10 years interest rates in Japan were almost zero, a situation similar to the one the Western nations are now facing due to the credit crisis. In the Japanese case it was directly related to the multi-year Japanese recession. Now, with interest rates so low, the women were afraid that they could not balance their household budgets. Different investments were needed. Knowing that interest rates in favorite countries (for holiday and shopping) like Australia, the UK, Singapore or even Turkey were much higher than in Japan they steered money out of Japan into those countries. Of course, the Yen is normally a stronger currency, but with international investments almost being non-existent the combined acts of Japanese women (and men) led to a money outflow that created a self-fulfilling prophecy. It generated downward pressure on the value of the Yen, which in fact made this strategy less risky. The strategies were solely coupon/interest rate driven, without too much worries about the principal and with this positive surprise and – in the end – always the possibility to ask for payout in the foreign country where it can then be spend on a nice holiday or some shopping, it is already a clear indication that women are here to stay in investing. Be it in the Western world or in Asia.

Best of both worlds; smart gender diversification within the investment team

It is surprising to see that this plea for more women in investing is NOT the same as saying that women dominate men to such an extent that we should get rid of the overconfident, alpha-male investors alltogether. Research does also indicate that the best solution is a mixed team with both men and women. Men are good in the high risk zones of the market that require alertness, speedy trading and strong nerves. Women are better in the low-risk zones of the portfolio and when acting combined one group can be a useful control set for the other. It is in the end all in the mix!

Conclusion: MEN SHOULD LEARN TO LIVE WITH THE FACT THAT WOMEN ARE MUCH BETTER WITH INVESTMENTS THAN MOST OF US ARE WITH HEELS. MIXED TEAMS WILL TAKE THE BEST DECISIONS BECAUSE THEY COMBINE THE STRENGHTS OF BOTH GENDERS.

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How do people invest? The difference between group and individual decision taking – with a small side-step to the credit crisis

Posted in Behavioral Finance, Financial Markets, Manager Selection with tags , , , , , , , , on March 11, 2009 by evd101

By Erik L. van Dijk

In our previous entry on Fund Manager Selection we noticed what the typical flaws of private investors and their advisors are. Now, before turning to decision taking by the so-called specialists in part 2 of the series on Fund Manager Selection, it is good to take into account resulst from a great paper by Barber, Heath and Odean from the Haas Business School at the University of California Berkeley. In their paper Good Reasons Sell; Barber, Heath and Odean, published in Management Science in 2003 they point out that individual investors take different decisions when being part of an investment club. 

A lot of the research focusing on differences between private and institutional investors incorporates agency-related factors in one form or another. The Agency Theory, going back to the original work of Mike Jensen and Bill Meckling in the mid-70s, indicates that situations in which a principal / decision taker is working in his own self-interest can lead to different outcomes when – for example because of the decision framework or company structure getting too large – he/she outsources part of the decision taking to an agent. Supposedly the agent is required to act totally in the interest of the principal / decision taker, but one can never exclude that the agent will incorporate his/her own agenda with goals/targets in the overall decision framework. Consequence: the end result can easily be less good than what the principal expected.

Before turning to investment decisions by institutions in a future post on Fund Manager Selection (part 2 of the series started yesterday), it is good to re-analyze the Barber et al. paper. In their paper they publish results from tests in which they distinguished between individual investors who took their investment decisions alone, and those who worked together in a group. Now with investors in an investment group still being the sole owner of their share of the overall group portfolio, the agency aspects don’t apply. Any difference in investment style of people in groups versus people on their own is therefore the sole result of behavioral factors.

The results are astonishing. People do decide differently when in groups. And not just that: people in general use decision processes in which ”good reasons” are guiding them more than conscious cost-benefit-analysis-based decision taking! Both the individual investors and the clubs in the Barber et al. study underperformed the benchmark, both on a net and gross basis. In other words: professional investors as a group do outperform. And that implies that the fun, anecdotes about King Kong beating the specialists with stocks picked by throwing darts are demagogic. The tests of monkey versus specialist do always incorporate 5 or less stocks and one ot the key characteristics of a good specialist portfolio is diversification. Taking away the diversification from the specialist, is like taking away bananas from the monkey. If you don’t give him his yellow, curvy food, he won’t be able to pick any stocks, let alone outperform.  

But the differences between the good, bad and ugly in both investor categories can be substantial. And that holds for both the professionals and the amateurs.

One standard mistake made by private investors is that they forget to diversify. Research has indicated that it is best to diversify a portfolio over 15-20 different, if possible not too-correlated holdings. In case your portfolio is too small: stick to funds and avoid individual stocks or other securities. The average investor club or individual diversified his/her portfolio over 5-10 holdings. The excess risk that results from this is one reason for the relatively meagre performance. Diversification was a bit better in the groups, but there diversification did not follow the lines of correlation reduction. It was more a way to ensure that everyone in the group had something funny and interesting to do, with others being able to mingle in the discussions. I.e. we diversify the research, but please make sure that the group discussions in the meetings that decide on portfolio changes are ‘fun’ with all respected members being able to show how knowledgeable they are.

This phenomenon can explain why securitized portfolios that were so instrumental in explaining the credit crisis were not diversified enough. A good group process would be one in which bottom-up specialists prepare things, bring their research into a meeting with eachother and with top-down specialists, with the latter than deciding ultimately about allocations. That is not what is happening in the case of investment clubs I am afraid. Actually, it is not even true for most institutional decision processes either. As top-down specialists, we believe that our cooperation with Noble Prize laureate dr Harry Markowitz (mr Diversification if you like) has helped us to take an objective stand by using a helicopter view in which we give credit to the bottom-up specialists that we categorized as best-of-breed.

No, decision taking in investment clubs follows a different path. Barber et al. show that ‘good reasons’ are the dominating factors explaining buy decisions. ‘Good reasons’ are labels and categorizations providing a seal of approval / quality stamp to individual stocks, albeit that the same could apply to mutual funds. Factors that fall under the ‘good reason’ definition could be; i) incorporation in a most-admired list (e.g. the one by Fortune); ii) strong sales growth of a firm over the last 5 years; or iii) strong stock returns over the last 3 years. With respect to the incorporation in most-admired lists: compare what we wrote in our previous contribution about advertising by mutual funds! And the 3-year return track record is of course one-on-one in line with what we wrote about raw returns in our previous post. ‘Good reasons’ are useful quality stamps, but not necessarily so for achieving above-average investment results: you have to pay for them. ‘Good reasons’ firms are more expensive, so that net results on ‘good reasons’ portfolios can be lower than on a contrarian one. That is how markets work: if something is more desirable, more people want it. And this higher demand translates into a higher price.

The fascinating thing is that people in an investment club are not agents, but principals! So, why do they decide the way they do? In our contribution on Fund Manager Selection by institutional investors we will show that the old adage ‘No one ever got fired for buying IBM’ is an important explanation in an agency setting. But the Barber et al. research indicates that there is more at stake. Group decision taking incorporates innate behavioral problems that can lead to sub-optimal investment decisions with or without agency complications. Investment portfolios should – in the end – lead to diversified mixes of individual holdings or mutual funds that are sufficiently different. Selection of different things involves different qualities. Different qualities require different type of people/specialists. Group processes with different people might lack the ‘social fun’ or a group process in which all like each other, respect each other, have fun working together. And that is where things go wrong. It is most likely that this problem plays a bigger role, the bigger the organization is. Investment clubs are normally limited to just 10-15 people, and already with those small numbers, the problems are tantamount.

Interestingly enough, it is not true that this problem arises solely in groups. Be they institutional (with agency problems included) or private (principal-only). Barber et al. show that the ‘good reasons’ problem is also bothering most individuals on a stand-alone basis when selecting stocks, albeit to a lesser extent. We can extrapolate this behavioral finding into another plea for making sure that boutique, smaller asset management firms in which a charismatic set of key personnel plays a leading role are not forgotten within a diversified portfolio of funds.

Bottom line: taking the right investment decisions – be they the selection of fund managers or the buying or selling of individual stocks, bonds or other securities – is a complicated thing. Too often, do we show weakness to quality-related factors, or non-investment-related agency factors, or do we fall prey to naive extrapolation of historical results. The ‘good reasons’ work by Barber et al. confirms this.

Conclusion: good investing requires a complicated skill set, that is unfortunately less readily availabe than we would like. It is not very helpful that the average marketing or business development executive of big financial institutions tries to make us believe that they are big because they are the best in everything they provide. The same holds for investor relations personnel (or the CFO or even CEO) of stock-market-listed firms trying to convince investors to buy their shares and hold them longer. The difference between ‘the good’, ‘the bad’ and ‘the ugly’ is complicated when it comes to finding the best investment portfolio. Avoiding ‘bads’ and ‘uglies’ alltogether will lead to underpermance. Buying the bads is not an option either. The best strategy should lead to a diversified mix of ‘goods’ (‘quality’) and ‘uglies’ (contrarian strategy components), but as a decision taker you need a strong stomache to defend the latter category, especially in harsh times.

POSTSCRIPTUM

Application example 1; Emerging Markets 2008

The fact that Emerging Markets – even the ones with strong fundamentals – lost more in the credit crisis than struggling but bigger (‘good reasons’) developed markets gives you an idea about what we mean here.

We at Lodewijk Meijer continue to believe that only a robust, cost-benefit-based approach in which all pluses and minuses are made transparant to the final decision taker (‘principal’) can lead to structural outperformance. That is why we combine ‘best-of-breed’ specialist products of a mix of large firms and boutiques in a framework in which we only play the top-down, objective outsider role based on a framework that we developed together with Noble Prize laureate dr Markowitz. Humble when necessary, bold when based on something and boring when it comes to risk: that is the right way to go for investors in this new era. Unfortunately too many decision takers didn’t come to that conclusion yet.

Application example 2; Will our leader be capable of getting us out of the current crisis?

And that does also seem to hold for the ones that are trying to lead us out of this credit crisis. Initially the G7 leaders and ministers of Finance tried to do it themselves. With the smaller developed nations playing copy-cat in their own country. But hey guys, if you let liquidity first flow towards the Chinese and Arabs through the acquisition of products, oil or direct investments, don’t be surprised that – when suffering a problem – liquidity is somewhere else. The receivers of liquidity in the aforementioned nations did not automatically send it back to Wall Street or London. Sure, sooner or later it will come, but at their convenience. Only now, months down the road do we see markets slightly improve and leaders change talk from G7 to G20. Finally! The initial money spent was printed money of future tax payers. If we want it or not, cost-benefit-based thinking would imply direct talks with the Chinese, the Arabs and other sovereign wealth investors. Our leaders have to be bold and humble at the same time when doing so. Difficult, but possible.

Fund Manager Selection Part 1; The Private Investor

Posted in Manager Selection with tags , , , , , on March 11, 2009 by evd101

by Erik L. van Dijk

On days like today, when stock markets bounce back like crazy and fears about the deepest recession in decades (that were talk of the town one week ago!) seem to have been forgotten, it is good to lean back and analyze some older research material. One of our specializations at Lodewijk Meijer is fund manager selection, based on our best-of-breed selection methodology. Our clientele consists of institutional investors like pension plans, banks et cetera. If there is one thing that we can learn from this crisis it is that both institutions and private investors make mistakes, albeit different ones. Private investors are prone to tunnel vision and myopic decision taking as a result of which they tend to take the same decisions at the same time, often guided by panic, fear and greed. Professor Hersh Shefrin’s book Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing should be made mandatory reading material for serious private investors. And that behavioral topics remain fascinating year after year, both in investing and other issues in life, was also shown last October when I organized a seminar in cooperation with French asset manager Ed. Rothschild Asset Management (EDRAM) for a Dutch audience of institutional investors. An old friend of mine, Professor Shlomo Benartzi of UCLA, was one of my keynote guests and Shlomo did what he always does: delivering a great speech, showing the audience what kind of amazing mistakes people make especially under stress or when faced with fear or greed situations.

But to what extent are there differences between Private Investors on the one hand, and Institutional ones on the other? Are the professionals really better? On the one hand one could say that pension plans and other institutions did at least not overreact when the credit crisis was on its way. When markets plummet and you cannot stop things anymore, because the fearful and panicky colleagues wanna hear just one word (SELL!!), you can better sit and wait and make sure that you hold fundamentally strong stocks in your portfolio, that will rebound as soon as markets come to realize that the overreaction has gone too far. The relatively low trading volumes of the recent months indicate that at least quite a few institutions are indeed playing their waiting game in a discplined manner, be it directly or indirectly when they have outsourced their investments to an external asset manager.

So that leaves hedge fund managers that have to unwind their excess leverage and the private investor as the main source of the incredible negative momentum of the last 12-15 months. They were selling, Western institutional investors – in as far as they weren’t banks that were struggling to survive after being fooled into terrible over-levered products by hedge fund managers or their own internal, ignorant staff – were doing nothing and the highly liquid wealth fund investors from China, Singapore and the Middle East were basically still waiting (with a few exceptions like Ping An, the Chinese insurance firm that stepped into Fortis at exactly the wrong moment).

But what was also clear, was that there was a separation within the Private Investor community. On the one hand, we had the private investors that invest directly in individual stocks and on the other hand we see fund investors. Now, research has indicated that it was especially the latter group that has caused the negative momentum. As if they did not want to hear the words ‘investment’ or ‘mutual fund’ anymore. It is therefore nice to analyze how this group of investors ‘thinks’. Jones, Lasseig and Smythe wrote an interesting article in the Journal of Financial Planning back in 2005 entitled Financial Advisors and Mutual Fund Selection. It is interesting to link their results to what we witness in today’s credit crisis. Markets that go down like crazy, many percentage points a day, when there is one negative piece of macroeconomic information, to markets that like today go up like crazy because of an email by mr Pandit, the CEO of Citibank, indicating that results of the first 2 months seem to be more than OK. Relief follows and there we go: 5-7 percent positive return in a day. Both are equally insane: the sudden drop (that didn’t kill us) and this ‘Phoenix from the ashes’ style price increase. The end of the world was not near, and neither is everything solved now. Only things we can be sure of:

a) There is liquidity out there, and it is in the hands of the wealth funds in Asia and the Middle East;

b) When interest rate cuts continue, we end up with an almost zero interest rate and that will trigger a return to stocks from the side of private investors and their advisors (including the mutual funds they use); and

c) The same interest rate cut will also make the cost of capital for firms so much lower that even the most risk averse might start to think about direct investments again.

When we add the effects of a, b and c up, we can be sure that the downward overreaction will be reversed. But unfortunately: it is almost equally certain that we will then move back to an also exaggerated positive momentum. In other words: excess price volatility around the volatility of the fundamental or fair value of stocks will remain, as already indicated many years ago by scholars like Robert Shiller and John Campbell. Compare for instance Shiller’s book Market Volatility.

So it seems that we have to ride the bandwagon and go with the flow. It is therefore good to know how the private investors using mutual funds take their decisions. If you cannot beat your enemy by being the only sane, rational guy out there, you better understand them and predict them! So let us get back to the Jones, Lasseig, Smythe (JLS) paper and study their results. Earlier research had already indicated that private investors focus strongly on a) mutual fund marketing and advertising when deciding which fund to buy (with later rumours and bad news being a strong beacon in mass selling actions); and b) raw returns. High absolute returns are proof that one should buy, and low absolute returns are a selling signal. Now, with studies showing that the average returns on asset classes are relatively stable, we can only conclude that this is exactly wrong! It is much better to buy when things are cheap and sell when things are expensive! The old work by De Bondt and Thaler on overreaction, as published in 1985 and 1987 confirms this. Only over shorter time frames (e.g. up to a year) are momentum strategies useful as part of a technical trading tool box.

But it is clear that a large part of the private investor community investing in mutual funds is not taking decisions alone, or they might not even be involved at all. There is a large financial planner and bank advisor community out there that ‘helps’ the unsophisticated private investor when picking or selling mutual funds. The JLS paper focuses on these advisors. About two-thirds of the private investor community uses such advice. Are these specialists mitigating mistakes that private investors themselves are prone to make?

The answer is yes. First of all, the advisors are not mislead by fund advertising as much as the DIY investor is. Second, they often have at their disposal comprehensive datasources like Morningstar or Lipper. Third, unlike many private investors they don’t make the mistake to look at raw returns only, but they also check relative return (i.e. return in relation to the return of a peer group or investor benchmark).

But were the advisors without flaws? Not at all! What went wrong is the following: advisors to private investors were sensitive to two common mistakes, namely

a) They paid not enough attention to fund costs and fees. Earlier research by Mark Carhart, now a big guy at Goldman Sachs Asset Management, has indicated that – if anything – the best funds were not the most expensive funds, but the cheaper ones. Reason: a good fund manager doesn’t want to make money via some kind of above-average fixed fee. No, he wants to attract money with a relatively low base fee, so that his assets under management become bigger (larger fee base) and then consecutively, he really likes to score through an excess-return related performance fee.

Isn’t it strange that the advisors paid so little attention to fees? Yes and no: on the one hand it might be logical to think that expensive is better, just like it is in for instance the car industry. A Mercedes is more expensive than a Hyundai and yeps, on average it is a better car. It is also logical when thinking about the following: advisors are also human, and they have to eat. To some extent higher fees might be higher, so as to allow the fund manager to pay a kickback fee to the financial planner/advisor. That would then explain a compensating effect that neutralizes the fee level factor. On the other hand, it is illogical not to look at fees according to Carhart. High returns from the past are no guarantee for the future. On the contrary, there is some mean reversion going on. Good managers of the past become on average less good in the future, and the lousiest of the past are on average not so bad in the future. Now, with fee levels being far more stable than returns, it is not logical not to take a more sophisticated look at them and incorporate them in the analyses. Remarkable: in most of the 18 asset classes in our proprietary selection system we did indeed derive quantitatvely that there is a negative correlation between fees and future results. We embedded the cost factor within our decision framework, and would be more than happy to provide you with more information about this, if you are interested in our manager selection services.

b) Fund reputation. Size matters far less than the advisors thought. Again, advisors are human. They are on the one hand – as we indicated above – better than their clients in that they are less sensitive to fund advertising and raw returns, but on the other hand did they turn out to be more than sensitive to ‘fund family size’. Big institutions with well-respected names got a much larger appreciation rating than they actually deserved when compared with nice boutique asset managers. Good fund boutiques need to score better results and work harder to convince financial planners/advisors than well-known big, fund factories do. And this is a big mistake. If anything, we often see that strong teams of investment managers working in big firms leave the big firm to start their own boutique.

Resume:

* Private investors that follow a DIY strategy in mutual funds are too much advertising and raw return focused. It is therefore logical that their ignorance is quite often translated into big disappointments, like in the 2008 credit crisis period. Nothing like the expected returns and nothing like the promises from the advertising really materializing!

* Financial advisors did a reasonable but not fantastic job in helping the private investors that felt that they couldn’t do the job themselves with their selection process. On average they did improve that decision process in some areas. However, a mix of potential agency problems (do we buy what is good for the client, or what provides us with a nice distribution fee?), status-related factors (we love to work with the big guys) and ignorance about cost related factors in the selection process, makes them far less effective than they should. In other words: manager selection is a special field, and just like stock picking not something every or the average accountant, bank employee, or broker is capable of. The good specialist selectors like ourselves, Russell, Bfinance, SEI and the likes have to be distinguished from the average advisor to private investors.

* There is a market for better, transparent and objective advice to Private Investors. Here in the Netherlands SNS Fund Coach is playing a helpful role, and there are many of those sites in the US. However, objectivity would imply that the data base manager hires some specialist to distinguish between ‘good’ and ‘bad’. Sure, that would still bear the innate risk of the advisor making mistakes, but the alternative – leaving too many things in the database so that the private investor cannot find what is good or bad – is worse.

ALL IN ALL, PRIVATE INVESTORS THAT INVEST VIA FUNDS DO – DIRECTLY OR INDIRECTLY – CAUSE EXCESS VOLATILITY. PARTLY DUE TO THEIR PANIC AND PARTLY DUE TO THEIR OWN MISTAKES, OR BECAUSE OF THEIR ADVISOR’S. THERE IS STILL A LONG WAY TO GO BEFORE THE PRIVATE CLIENT RELATED SIDE OF OUR BUSINESS WILL BE REALLY MATURE. IT IS THE RESPONSIBILITY OF ALL OF US IN THE INDUSTRY – PROFESSIONALS, ORGANIZATIONS OF PRIVATE INVESTORS, GOVERNMENT BODIES – TO UPGRADE KNOWLEDGE AND SOPHISTICATION LEVELS AS QUICKLY AS POSSIBLE. THE HIGHER AVERAGE RETURNS AND LOWER RISK THAT PRIVATE CLIENTS WILL BE EXPERIENCING AS A RESULT OF THIS, WILL BE BENEFICIAL TO THE FINANCIAL SYSTEM AS A WHOLE.