Does behavioral finance present undiscovered opportunity for active managers?
Does behavioral finance present undiscovered opportunity for active managers?
The book “Return of the Active Manager: How to apply behavioral finance to renew and improve investment management,” puts forth fresh ways in which investment managers can use behavioral principles to push the envelope in active portfolio management.
Tom Howard and Jason Voss might just be the odd couple of behavioral finance: one, a buttoned-down professor emeritus who retired from the content-laden world of academia to manage portfolios; the other, a digital-age independent thinker who parlayed success in managing a portfolio to move into content.
Their common link? A passionate and enlightened view of what behavioral finance can do for active investment managers, coupled with an unselfish desire to share their story with other professionals. Howard is now the CEO/CIO of AthenaInvest Inc., while Voss, formerly the content director for the CFA Institute, runs Active Investment Management Consulting. Both are frequent public speakers and industry networkers.
Their firms’ respective websites have telling quotes that reveal something about their beliefs:
“Markets are not efficient and people are not rational.” (AthenaInvest)
“By definition, earning alpha means doing what no one else is doing. This requires not only analytical firepower, but also creativity and intuition.” (Active Investment Management Consulting)
Their book, published this summer, is called “Return of the Active Manager: How to apply behavioral finance to renew and improve investment management.” What makes this book particularly noteworthy is the focus on the interface between an advisor or manager and the process of investment management. It puts forth fresh ways in which investment managers can specifically use behavioral principles to push the envelope in active portfolio management. The fact that it was written by managers for managers (and financial advisors) gives it not just originality, but credibility as well.
Importantly, Howard and Voss recognize that the behavioral perspective is a double-edged sword—that the markets present behavior-based anomalies and mispricings that can be exploited by savvy managers, and that addressing a manager’s own behavioral biases can improve their performance regardless of what their strategy is. Furthermore, they understand that the latter may be the more powerful of the two in producing measurable results.
“Return of the Active Manager” addresses topics such as behaviorally enhanced fundamental analysis, active equity-fund evaluation and selection, harnessing big data, and investment-firm structure.
The book opens its case with solid support for active management and pronounces that the opportunity for active managers lies in the very trend that has been drawing money away from them: the tidal wave of capital pouring into passive funds. Citing multiple studies on the subject, the authors conclude that the continuing deluge of money into passive index-hugging funds renders many stocks increasingly mispriced, thereby providing the inefficiencies that active alpha-seekers feed on.
At the same time, the authors feel that many active managers have strayed from a focus on total return years ago, succumbing instead to the unrealistic demands of an audience that expects outperformance relative to benchmarks, but with all of the same risk and volatility characteristics.
As the book notes, “When the performance of investment managers is compared to a stock index and all of its characteristics, not just its total return, then it is by definition impossible to beat the benchmark.”
The authors drive this point home with a compelling analogy using world-famous sprinter Usain Bolt. “Yes, it is possible to beat Bolt in a 100-meter dash, the equivalent of a rules-based, defined context … a race. But is it possible for another sprinter to beat Bolt if he is asked to be the same height, weight, have the same stride, the same acceleration, the same lean, and so on?” The point should be for another sprinter to win the race, not to beat Bolt while trying to emulate him at the same time.
Once the book sets the stage for success in active management (also citing an abundance of research supporting the contention that stock-picking skill actually does exist), it moves on to point out the flaws in classic theories they feel active managers need to recognize to turn that skill into alpha.
On the subject of modern portfolio theory (MPT), for example, Howard and Voss claim that “MPT was supposed to introduce science into investing via mathematical modelling. But the rationality assumptions needed to shoehorn markets into a form that could be modelled mathematically were just too extreme. … It turns out accepting markets as they are, full of humans with considerable emotional baggage, is superior to the neat packing provided by MPT.”
The authors don’t pull any punches and are willing to take an unorthodox approach to subjects that others blindly accept as given.
One of these subjects is risk. For example, they take serious exception to a reliance on volatility as an effective measure of long-term risk. Instead, they view it as bumps along the road, something investors need to accept like the “turbulence on an airplane flight.”
The greater risk in their minds is underperformance, and they point directly to overdiversification (leading to closet indexing) as the culprit. They advocate placing a nonproportional emphasis, for example, on “best-idea” stocks, citing research that shows notable performance improvement just for that.
Mainstream research bears them out on their attempt to read the behavioral tea leaves that provide hidden opportunities in investment management. For example, MIT/Sloan professor Eric So analyzed 19,000 scheduled earnings announcements from 4,000 companies covering the period 2006–2013.
The research set out to determine whether there was a statistically predictive behavior among those who delayed their earnings announcements by a week or more versus those who advanced them by the same amount. After all, it’s basic human nature to be eager to share good news and hesitant to share bad news. The research soundly substantiated So’s suspicions. Indeed, a simple “tell” on whether earnings are going to be unexpectedly good or bad can be gleaned from the timing of the announcements, and the market was not reacting to this tell until the announcements were ultimately made. Howard and Voss believe that a little behavioral sleuthing can unearth other such “tells” from corporations.
The book positions behavioral finance as a “diagnosis without a prescription,” setting the stage for a variety of prescriptions that the authors subsequently provide. These prescriptions are neatly packaged into separate chapters about financial advisors, the equity-investment process, fundamental analysis, manager search, quantitative analysis, and even managing the active investment-management firm.
It begins by identifying foundational premises about markets being informationally inefficient, investors not being rational, and alpha-laden price anomalies existing throughout the markets. It then proclaims that “managing emotions may be the most important determinant of long horizon wealth.”
The book is not positioned as a formula to follow but rather a compendium of ways in which Howard and Voss see opportunities arising from behavioral factors. The objective is for managers and advisors to pick and choose what aspects resonate with them. Ideas from the book are as far-ranging as Voss’ tips on reading subtleties from financial statements to Howard’s unique way of evaluating style-drift among outside managers.
The authors know how an active investment manager thinks, acts, obtains, and processes information. This enables them to offer insights not just on the aspects of the investment process that all investors are faced with, such as news bias and overreaction, but to tackle those aspects unique to active managers and advisors, such as interpreting management behavior or interviewing a fund manager or corporate CFO.
They know that an important consideration for managers is the tracking not just of performance, but of the drivers of performance. On this subject, the book provides unique and insightful advice on how to view a financial statement not just as a snapshot of current financial conditions, but as a window into the behaviors and intentions of the company’s management team. They also see quarterly conference calls or direct interviews as “unparalleled moments during which clever active managers can really get a sense of the behavioral tendencies of management.”
Once “Return of the Active Manager” makes its case regarding manager skill and market inefficiency, it moves into a manager’s head, offering specifics on how to introduce a behavioral perspective to their everyday activities.
For example, it is imperative for a manager to understand how much of their performance in any given period was due to an identifiable and replicable skill versus being in the right place at the right time (i.e., chance). That’s very different from performing conventional analytics about where performance comes from in terms of asset classes, sectors, factors, and so on. In order to measure chance versus skill, a manager needs to track all decisions, tag each one with an opinion or justification, and analyze the results regularly. Howard and Voss recommend an “opinion journal” (or what some call a “decision journal”), and they explain how to set one up.
The journal isn’t complicated or expensive. It is merely a tool for developing self-awareness about investment behavior and a discipline for monitoring that behavior at the times decisions are being made. One of the common biases a journal can help improve is confirmation bias: the subliminal tendency to seek out information that agrees with our existing view on something. Under normal circumstances, we fall victim to this bias without realizing it. In fact, by reading a second source that confirms our belief, our conviction merely gets stronger and our confidence greater that we have an effective course of action. The journal, however, should require one to pause and establish a contrary viewpoint.
Recognizing the value of this technique, the Supreme Court places high importance on the discipline of dissenting opinions, and they can form the basis for future reviews of an issue. Voss offers an investment variation on this, making sure with important news items to read an opinion on it from a source most likely to have a different viewpoint. (Wondering about a Brexit-related trade, for example? Don’t rely just on the London Times’ view of things—check a French or German news source for a different spin.)
One of the distinctive aspects of this book is that it doesn’t diminish in any way the importance of fundamental analysis or attempt to dissuade the use of fundamentals when analyzing securities, funds, or managers.
It simply says that adding a behavioral perspective renders fundamental analysis a more robust and comprehensive exercise. In a sense, this simply legitimizes an activity that already takes place but is often less structured. Insightful managers are always trying to look beyond the numbers, read the tea leaves, and interpret the message underneath. Is management truly exuding confidence, or are they telling the public what they think it wants to hear? Are they making a strategic business turn to take advantage of an opportunity, or did they pivot as an act of desperation? They just laid off hundreds of employees—are they bowing to investor pressure to cut costs, or are they undoing a strategic mistake?
Not being content to simply read tells from financial statements, the authors invoke other means of using behavior to gain an edge. Voss’ work in lie-detection and insights on body language are examples of this.
Additionally, there is the behavioral side of manager search with a barrage of studies and statistics relative to the inadequacies of performance chasing. One of their citations is a 2018 study by Paul Kaplan, Morningstar director of research, and Maciej Kowara, associate director of manager and quantitative research. The study concluded from a worldwide sample of 5,500 active equity mutual funds that two-thirds outperformed their benchmarks, gross of fees, over the 15-year period of 2003 through 2017, but that the typical outperforming fund actually underperformed for a period of 9–12 years within the 15-year sample period. This means that the fund’s outperformance could be concentrated in only three to six years out of a 15-year period, raising serious concerns about the adequacies of using 3-, 5-, and 10-year performance numbers—the ones that form the basis of Morningstar’s popular star rating system for mutual funds.
Readers of this book will find it highly supportive of the notion that manager skill does indeed exist and that it is too often masked or overshadowed by managers’ own behavioral biases, including the most sinister of all in the authors’ minds—the tendency to stay closely tethered to the benchmark, thereby succumbing to the inevitable fate of closet indexing.
Howard and Voss bring this up as an opportunity rather than a criticism, though, and they offer plenty of suggestions on how managers can let their skill shine through. Moreover, many of their suggestions are somewhat simple to implement, once the constraint of one’s own behavioral opposition is overcome. That means the goal of higher relative performance does not necessarily require a huge investment in technology or additional support staff. It simply requires behavioral discipline, which might just necessitate some soul-searching rather than a material change in strategy or technique.
There is now a growing library of books on behavioral finance and a host of experts such as Thaler, Kahneman, Ariely, and Crosby who can provide you with an excellent education on behavioral biases and their impact on our decisions. But if you are directly involved in active investing and you are open to a fresh take on your craft from two experts who walk in your shoes, you might consider making room for “Return of the Active Manager” on your bookshelf.
Richard Lehman is an adjunct professor of behavioral finance at UC Berkeley Extension and at Golden Gate University. He also teaches alternative investments at Hult Business School. He has more than 30 years of experience in financial services, working for major Wall Street firms, banks, and financial-data companies. Mr. Lehman is the founder of BehavioralFinance.com and produces the Behavioral Finance Symposium, an annual educational event for financial professionals held in San Francisco.
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