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OPINION

A second-best case for funds

A second-best case for funds
October 31, 2014
A second-best case for funds

Tom Chang and David Solomon at the University of Southern California and Mark Westerfield at the University of Washington point out that investors behave very differently towards shares and actively managed funds. In individual shares, they are prone to the disposition effect: they hold onto losing stocks while selling winners. But in funds they do the opposite - they sell past losers and buy past winners.

This difference, they say, is because of the way investors respond to cognitive dissonance - the discomfort we feel when two of our beliefs are inconsistent with each other. When one of our stocks does badly, we feel this dissonance because our belief that we are good investors clashes with the fact that we've bought a dud. Our reaction to such dissonance, says Professor Chang, is to resort to "defence mechanisms and mental tricks". One such trick is to persuade ourselves that it is the market that is wrong, not us, and that the stock will bounce back: such a trick is, of course, not always wrong, which is what makes it so appealing. This causes us to hold onto losing shares.

When we buy a dud fund, however, our response is to blame the fund manager rather than ourselves: it is always easy to blame others for our misfortunes. We can therefore sell the fund without feeling bad about ourselves - which means we are more likely to do so.

This difference between how we treat funds and shares creates two reasons for some investors to buy actively managed funds.

One is that it gives them a backdoor way of investing in momentum. Investors who hold onto losing stocks are, in effect, betting against momentum while those who cut their losers and run their winners are betting with momentum. Given that momentum investing pays off well on average over the long run, investing in funds might therefore be a way of investing in momentum.

Of course, it would be better still to wise up to the disposition effect and be a deliberate momentum investor. For those who cannot do this, investing in funds might be a roundabout alternative.

Secondly, the tendency to cut losing funds and buy winners changes the payoffs to investing in funds. If we are quick to sell bad funds, the downside to them is limited. But the upside to a good fund is greater, because we can invest more later in the minority of funds that do well. In this sense, investing in funds becomes like investing in small-scale pilot schemes; our losses are small but our gains potentially bigger.

Now, I'm not sure that these arguments are entirely sufficient to overcome funds' high fees - which, remember, compound horribly over time. They do, though, hint at an intriguing possibility.

To see what I mean, remember the theory of the second best, proposed by Richard Lipsey and Kelvin Lancaster back in 1956. They proved that in a world where full economic optimality is impossible governments can sometimes improve welfare by introducing another market distortion; if there is a monopoly, for example, price controls might be a decent second-best alternative if the monopoly can't be broken up. Might there be an analogy here with rationality? If full rationality is impossible, we might be able to improve our results by behaving in a way that seems irrational from the point of view of full rationality. Perhaps if we cannot rid ourselves of the disposition effect, there is a place for actively managed funds even if these would have no part of the portfolio of a fully rational investor.