Actively managed funds “did not outperform their own benchmarks after fees” said the FCA last year in a report that officially corroborated the bulk of academic evidence that passive investment beats active management over the long term. Which poses the question: why do so many people continue to hold high-charging but poorly performing funds? Some new research suggests it is in part because investors are irrational.
JB Heaton at the University of Chicago and Ginger Pennington at Northwestern University surveyed more than 1,000 Americans with incomes over $100,000. They told them of a hypothetical fund and asked which is more likely – that it will make good returns, or that it will make good returns and employs hardworking analysts trying to find good stocks?
The latter cannot possibly be the correct answer simply because a combination of two things cannot be more likely than a single thing. Nevertheless, most respondents answered the latter. They committed the conjunction fallacy.
They did so, say Heaton and Pennington, because they were “misled by belief in the work ethic”. Because they believe that hard work pays off, they believe that it leads to good returns. They overlook the possibility that a fund manager can earn good returns by being lazy – by simply tracking the market. Of course, hard work often pays off in other domains. But in investing it need not do so. People fail to see that what works well in some areas of life doesn’t necessarily do so in others.
Some other common errors of judgment reinforce this mistake. One is the just world illusion. People want to believe that the world is fair. And the wish is father to the belief. So people think that those who work harder will do better than those who don’t – that being active will lead to better results than being passive.
Another error is the illusion of control – the idea that, with effort, we can control or predict what are in fact chance events beyond our control.
Some experiments at the Autonomous University of Barcelona have highlighted how easily people make this latter mistake. Jordi Brandts and colleagues got people to predict a series of coin tosses and then offered others the chance to pay to back the predictions of the luckiest predictors. They found that most subjects did so, which shows just how easily people mistake luck for skill.
If you think that’s a freak finding, it is not. For one thing, it corroborates similar experiments in Thailand and Singapore. And for another, it fits with a longstanding fact about fund management – that investors tend to buy funds that have done well in the recent past even though past performance is, at best, only a weak guide to future performance.
Other mistakes also bias people towards active managers. One is overconfidence. Sebastian Muller and Martin Weber at the University of Mannheim have shown that even sophisticated investors overestimate their ability to find good fund managers, and so invest too much in expensive poorly performing funds.
Another, says Meir Statman at Santa Clara University, is a simple inferential error. People believe that stock markets are informationally inefficient and leap to the conclusion that this means it is easy to beat them. But this does not follow at all. In fact, there are very few well-attested ways of outperforming without taking on risk, and the two main ones (momentum and defensives) do not require very much conventional active management.
On top of all this there is simple path dependency. Many people don’t much change their investments from year to year. If they’ve made bad choices, therefore, they stick with them. And active managers have a form of first-mover advantage – the fact that they existed for decades before tracker funds gave them a familiarity and hence an incumbency advantage that lingers to this day.
None of this is to say that all investments in active managers are irrational. They’re not. There are some better reasons for them.
One is that there’s a good case for investing in unquoted stocks, because future growth might come from companies that are not yet listed. This requires active managers.
Also, there are some circumstances in which most active managers should beat tracker funds. If smaller stocks outperform larger ones then most stocks will beat capitalisation-weighted indices and so picking shares at random should beat the market. Given that small-caps have only sometimes beaten larger stocks over the past 30 years, this only justifies temporary investments in active funds rather than long-term ones.
What’s more, investors might reasonably pay a premium to invest with fund managers they trust.
And it might not be unreasonable to take a bet on the chance that one or two fund managers might beat the market – although holding lots of funds diversifies away these chances of outperformance.
These good reasons for holding actively managed funds, however, are not the only ones. There are also potential errors of judgement that bias people towards actively managed funds. By contrast, I find it hard to think of biases in the other direction – ones that cause us to own too many trackers. It’s likely, therefore, that investors own too many actively managed funds.
