Behavioral finance is often described as the study of human behavior and cognitive psychology using the tools of traditional economic and financial theory to explain why people make irrational decisions that can lead to investment mistakes, such as the mispricing of assets.
The field of behavioral finance has seen a great deal of attention in academia over the last decade or so as pricing anomalies continue to be discovered. This has led to a number of useful insights regarding the types of errors of judgment investors make.
Related to this surge in academic interest, a number of mutual funds have begun marketing themselves as “behavioral funds” with a strategy to exploit “anomalies” in asset pricing.
Study shows “behavioral funds” underperform
Nikolaos Philippas (University of Piraeus, Greece) was the author of “Did Behavioral Mutual Funds Exploit Market Inefficiencies During or After the Financial Crisis?”, which was published in 2014 in the Multinational Finance Journal.
This study looks at data from January 2007 through March 2013, examining the performance of 22 U.S. behavioral mutual funds (ie, funds that use investment strategies based on behavioral finance).
As a basis for his research, Philippas hypothesized that the 2008-2009 financial crisis would be an ideal time to test behavioral theories because crises often lead to herding behaviors, which then lead to bubbles and crashes.
With the idea that mispricings during the financial crisis period would make it more difficult for institutional investors to exploit mispricings compared to opportunistic mispricings stemming from the behavioral biases exhibited by investors following the crisis, Philippas undertook a subperiod analysis that distinguished between the crisis period (January 2007 to December 2009) and the post-crisis period (January 2010 to March 2013).
Next, he applied multiple measures and multiple factors (beta, size, value and momentum) to calculate whether the behavioral funds were actually generating alpha.
The study results show that behavioral mutual funds exhibit poor performance during the recent financial crisis and in its aftermath, thus rejecting the hypothesis that the crisis period was an ideal environment for behavioral funds strategies to exploit market inefficiencies and investors’ behavioral biases.
In fact, the managers of behavioral funds neither outperformed their benchmarks nor showed any market-timing ability.
Moreover, the data showed there was not even one behavioral fund that yielded an economically or statistically significant CAPM alpha (Jensen’s alpha) in the full sample period. Eight funds, however, produced significantly negative alphas.
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