AUG 19, 2001
Some Funds Try to Read Your Mind
By ELIZABETH HARRIS
he developing field of behavioral economics, which blends economics and psychology, has attracted much attention recently, as many people hope that it will lead to insights that can help investors avoid falling prey to fads like the Internet bubble that popped last year.
But so far, attempts have failed to fully harness for investment the work of academics like Richard H. Thaler, a professor of economics and behavioral science at the University of Chicago Graduate School of Business and the field's leading figure.
The handful of mutual funds using the theory have a decidedly mixed record.
But Mr. Thaler says research by him and others holds practical promise, even if Wall Street peregrinations cannot be fully fathomed just yet.
"There's been more progress on the individual cognitive psychology over the last 20 years than on mass psychology," Mr. Thaler said. "If we had a model that would have been able to tell us when the Internet bubble would break, believe me, we would have used it. So it's easy to say in hindsight that there was some sort of euphoria for two or three years and that euphoria has died. But nobody has the tools, at least as far as I know, that allow you to forecast these changes in these moods."
Still, he is trying to capitalize on developments when possible. Fuller & Thaler Asset Management in San Mateo, Calif., the firm of which he is a principal, has been investing privately for nine years, trying to put the academic theories to work using real money. And it has been quite successful. It says it has produced a 21 percent annualized return for the growth style of investing, about double the gain of its benchmark, the Russell 2500 Growth index. Over the same period, the Standard & Poor's 500-stock index has risen an average of 14 percent a year.
But while the strategy may be working for the firm's separate accounts, one of the two public funds that Mr. Thaler helps to advise has not distinguished itself during its shorter life span. The two are the Undiscovered Managers Behavioral Growth fund, managed by Frederick W. Stanske, 43, and the Undiscovered Managers Behavioral Value fund, managed by Brendan S. MacMillan, 33. Both funds require $250,000 investment minimums.
The growth fund, with $120 million in assets, returned an annualized 2 percent from July 1998 through last Thursday, compared with 7.5 percent for the average mid- cap growth fund, according to Morningstar Inc., and 3 percent for the Standard & Poor's 500. In 1999, the fund led its category with a 65 percent return, but a year later, it fell behind, dropping 27 percent. As with most growth funds, the returns "stink now," Mr. Stanske said.
"Obviously," he added, "we had too much tech exposure, even at the beginning of the year."
The value portfolio, by contrast, which Morningstar classifies as a small-blend fund, has done well during the market downturn, along with other value investments. The $35 million mutual fund has gained an average of 25.2 percent a year from its inception in December 1998 through Thursday, according to Morningstar. This year, it is ahead by 15.5 percent through Thursday, beating its peer group, which rose 5.5 percent on average.
Both funds operate on the theory that people bring biases to their investment analysis and that these are reflected in prices. And because most people are unaware of their biases, they usually do not adjust their investing. Mr. Stanske and Mr. MacMillan try to find such patterns in the market, and to exploit them.
Terrance Odean, an assistant professor at the University of California at Berkeley, who also specializes in behavioral finance, said, "As long as a large-enough majority of people are making these little mistakes, there's probably an opportunity to make money by being on the other side."
But in practice, the funds share some stock-picking similarities with other growth and value portfolios, even if they are rooted in Mr. Thaler's work. For example, Mr. Stanske seeks "underreaction" when considering stocks for the growth fund. That occurs when analysts and investors believe too firmly in their estimates of what companies will earn in a given quarter and overlook signs to the contrary.
Mr. Stanske cites his finding that analysts dismissed strong earnings from Coach Inc. (news/quote), a maker of handbags and briefcases, when concern rose about leather prices. But he observed that investors appeared not to notice that Coach was relying less on leather than it had in the past. Mr. Stanske said he bought the stock at the beginning of the year "in the 20's." It closed at $33.65 on Friday.
As for the value strategy, Mr. MacMillan said he tried to identify "overreaction" to companies that had experienced a long period of underperformance by looking for signs that they were beginning to improve.
He pointed to Sola International Inc. (news/quote), a maker of eyeglass lenses, whose shares were unduly depressed, he said, by the emergence of laser surgery. Investors had largely ignored a new management's efforts to correct longstanding corporate problems. Mr. MacMillan said he bought shares in the $5-to-$6 range last summer; the stock closed at $14.22 on Friday.
Fuller & Thaler is not alone in developing investments based on behavioral concepts. ABN AMRO (news/quote) Asset Management runs two such funds, with assets totaling 160 million euros, or $146.9 million, focused on European markets; it also has one for Japan. The European funds are ABN AMRO Ratio Invest, which began in April 1999, and the ABN AMRO Behavioural Finance, which opened to new investors in May 2000.
The Ratio fund gained 3.1 percent from inception through July, lagging behind its European benchmark, which returned 8.4 percent, according to Arjen B. Pasma, the ABN AMRO Ratio portfolio manager.
The funds follow neither growth nor value investing styles, Mr. Pasma said. Rather, he uses a model that identifies stocks out of favor or undervalued because of emotional or psychological factors.
"If you want to exploit irrationalities, you should use something that is rational or emotionless like a model," he said.
But nobody in the field pretends to have found the key to easy riches. "The problem with investing is you can't be just a psychologist," said Robert J. Shiller of Yale University and a proponent of behavioral economics. He said that all successful investors become involved in the industry to which they commit money and become aware of how other investors might overlook some developments and overemphasize others. "People like Dick Thaler are so rare in the investment world that he probably has a niche, an advantage that he can exploit," he said.