Episode 268: Itzhak Ben-David: ETFs, Investor Behavior, and Hedge Fund Fees

August 31, 2023 Angelica Montagano

Professor Itzhak ("Zahi") Ben-David is the Neil Klatskin Chair in Finance and Real Estate at The Ohio State University Fisher College of Business. He serves as the Academic Director of the Ohio State University Center for Real Estate. He teaches real estate finance classes to undergraduate and MBA students.

Dr. Ben-David has published in top finance and economics journals, such as Quarterly Journal of Economics, Journal of Political Economy, Journal of Finance, Journal of Financial Economics, and Review of Financial Studies. His area of specialization is the real estate market, the financial markets, and behavioral finance. In his research on real estate he explores the drivers for the housing bubble and the aftermath of the financial crisis. His research on the financial markets focuses on the behavior and effects of institutions in the equity market. In behavioral finance, Dr. Ben-David writes about behavioral biases of managers, investors, and households.

See this content in the original post

Today, we are joined by Professor Itzhak Ben-David, the Neil Klatskin Chair in Finance and Real Estate at The Ohio State University (OSU) Fisher College of Business, and the Academic Director of the OSU Center for Real Estate. In this episode, we look at the impact that ETFs have on the pricing of their underlying securities, and how innovation in the ETF space affects investor outcomes. We discuss Morningstar Star ratings and how a change to their structure in 2002 affected fund flows and asset prices, and we cover some mind-blowing data regarding the hedge fund fees that investors actually end up paying. We also dive into miscalibrated expectations, how people treat their tax refunds, and so much more. This conversation makes for an incredibly diversified overview of a variety of topics that are relevant to financial decision-making. Finance experts and household decision-makers alike will find value in this episode. Regardless of your level of experience, tune in today to learn more.

Key Points From This Episode:

(0:03:27) Professor Ben-David’s take on the current state of the ETF market.

(0:07:37) Ways that investors are affected by a broader variety of ETF options.

(0:16:46) Advice for investors who have been lured in by a sector or thematic ETF.

(0:17:53) Mutual or hedge funds versus ETFs and their impact on underlying securities.

(0:26:38) Reflections on the behaviour of mutual fund investors (learning versus luck).

(0:33:01) How we can learn what investors care about from mutual fund flows.

(0:37:15) Why investors typically put their money where the Morningstar ratings are.

(0:38:46) Morningstar’s rewiring of the “star” system in 2002 and its repercussions.

(0:48:54) The effect of Morningstar ratings on mutual fund flow and momentum.

(0:52:40) Hedge fund investor behaviour versus mutual fund and ETF investors.

(0:54:46) The “two-and-20" hedge fund fee that sets it apart from mutual funds.

(1:00:53) What happens after investors pull their money from a hedge fund after a loss.

(1:02:19) How hedge fund incentive fees correlate with hedge fund performance.

(1:04:09) Key lessons for investors who might be considering allocating to hedge funds.

(1:07:15) How people treat tax refunds differently from other income and expenses

(1:13:20) Defining miscalibration and the behavioural bias that overconfidence presents.

(1:19:26) How CFO miscalibration responds to rising market uncertainty (and how to avoid it).

(1:22:58) Professor Ben-David’s definition of success in relation to failure.

Read The Transcript:

Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We're hosted by me, Benjamin Felix and Cameron Passmore, portfolio managers at PWL Capital.

Cameron Passmore: Welcome to Episode 268. Ben, another incredible guest that you were able to find for this week's episode. We welcome Professor Itzhak Ben-David. We had an incredibly diversified conversation about so many different but wildly fascinating topics in the area of finance. Let me set up the background and you can jump into more detail. Professor Ben-David is the Neil Klatskin Chair in Finance and Real Estate at the Ohio State University Fisher College of Business. He's also the Academic Director of the OSU Centre for Real Estate. He holds a PhD in Finance and an MBA from the University of Chicago, a BS and an MS in Industrial Engineering, a BA in Accounting from Tel Aviv University, and an MS in Finance from the London Business School. Why don't you take it from there with that setup?

Ben Felix: I mean, listen, I'd read many of Professor Ben-David's papers, and it just came to a point where I had to invite him on. There comes a point where it's like, when someone's got so much interesting research, especially in this case in so many different areas, that's one of the incredible things about his research, but also about these conversations that it’s – and we didn't even touch on some of his major areas of research. We didn't talk about real estate, which he's got a ton of research on. But, I mean, that's the story. There's so much interesting stuff here that's relevant to financial decision-making at the household level, we had to have him on.

Cameron Passmore: We went from research around Morningstar ratings and the change that happened in 2002. Hedge fund fees with some mind-blowing data in there.

Ben Felix: I say this in the episode, too. That paper is just incredible. It's this counterintuitive thinking. Your intuition would never pick this up. The idea of hedge fund fees. How much do you actually pay when you invest in hedge funds? It's not two and 20. I won't spoil the answer, but that's an incredible paper. We talked about ETFs, too. That's how we kicked off the conversation on the impact of ETFs on the underlying securities, but also the impact of ETFs on investor outcomes, ETFs as a form of financial innovation and how they impact investor outcomes. That is more choice good for investors is the theme there, but that's just fascinating stuff.

Cameron Passmore: But wait, there's more. We jumped into calibration, CFOs and how they calibrate and overconfidence. Then just for some spice at the end, we dove into tax refunds and the mental accounting that people do with their tax refund amounts.

Ben Felix: Yeah. How do people treat their tax refunds and why do they get treated differently from the rest of their income? That's one that's just so relatable, but to see it investigated rigorously is great.

Cameron Passmore: It was all relatable. It was a great conversation. Zahi, he's a really, really nice guy, too. It's a really fun conversation.

Ben Felix: Yeah. I enjoyed it immensely. I think that's a good enough introduction. We’ll go ahead to the episode with Professor Itzhak Ben-David.

***

Ben Felix: Professor Itzhak Ben-David, welcome to the Rational Reminder Podcast.

Itzhak Ben-David: Yeah. Thank you for having me.

Ben Felix: All right, so let's kick it off. What is the current state of the ETF market?

Itzhak Ben-David:When we think about the ETF market worldwide and in the US, we see thousands of ETFs. In some markets, you have more ETFs than stocks, or securities being traded. If you think about the history of ETFs, they started in 1993 with the SPDR. Originally, this used to be targeted towards institutional investors who wanted to invest in the S&P 500, but didn't want to hold futures, because they don't allow direct ownership of the underlying securities, ETFs too.

In the 90s, it developed. The QQQ joined at some point. We started with broad indices. As the industry developed, there was fee compression. The competition was really about how do I attain the most liquidity, best coverage of indices at the lowest fees? Now, think about generating a new product into this market. What you want to do really is to find something that is going to be compelling for investors that doesn't exist already in the market, because competition is difficult. What we see is that more and more new products have been introduced. Each one is now differentiated a bit from the existing products. New products become going after greater niches in the market, appealing to more specific groups of investors.

If you look at the timeline, you see broad index or broad-based ETFs. You only see both small beta, these are the value and growth, dividend-paying it such. We see sector and industry ETFs. Now we're looking at the mid-2000s, we start looking at thematic ETFs. Basically, these are ETFs that are defined around a very specific topic. These could be firms that have something to do with vegan foods, or firms that have to do with SIMs, or no SIMs, or attached to a religion, or firms that their board support Trump, or something like that. When we look at the industry today, 2023, we see the history of all the ETFs that were launched in the past and survived.

Ben Felix: Yeah, it's super interesting. I guess, right now, lots of maybe AI thematic ETFs being launched. When you look at ETF issuers, how are they deciding which products to launch?

Itzhak Ben-David:Right. Think about the three of us deciding to launch an ETF, how would we go about it? Well, we know that it probably costs around $100,000 to launch a new ETF. We probably can't compete with BlackRock or Vanguard. We don't have the economies of scale, so we're not going to go for a new S&P 500, or a new NASDAQ-based ETF. We're going to look for something that investors will be interested in, that we will be able to generate some fees and probably something that has less competition than others. Maybe something based on AI, something based on the current topic, maybe something anti-woke, or for woke, or some other topic that investors care about, right?

Now, one way to know what investors care about is to read the newspapers and see which type of stocks, or which stocks performed really well. This means that investors are probably excited about these type of stocks. If you look at the recent history of ETFs, think about 2020, COVID period, we saw ETFs dealing with vaccines. We saw ETFs holding firms related to work from home. These are hot topics, right? Things that investors are interested in at the moment. I think for the three of us, this perhaps could be an interesting venture.

Ben Felix: It's crazy, though. I saw somebody tweeted, maybe last week about a cannabis ETF that has now lost 90% since it was launched.

Itzhak Ben-David: Yeah. This is so 2019. Cannabis, right? It can join the vegan foods.

Cameron Passmore: How does a broader menu of ETF options affect investors?

Itzhak Ben-David: You could think about ETFs as value-enhancing, right? This is about the democratization of investments. These are tools that were very privy to professional managers before and now are available to anyone. I mean, if you were a retail trader in the early 1990s or late 1980s, you couldn't trade the S&P 500 in one trade. Today, from the ease of your smartphone or your palm, you could actually trade the S&P 500, take a long position, short position, leverage, etc. One view is that this is about the democratization of investments. We allow investors more power.

A second view is what is called a competition for attention. This view is the general view of competition. It basically says, consumers have limited attention. When you launch a new product, whether this is a yogurt, or an ETF, you need somehow to attract your consumers' attention, investors' attention. How do you do that? Well, one way to do that is to compete on price, lower spreads, better liquidity, get more value for your money. The other is called quality. Quality here is very general. It's, here's a new flavour of yogurt. Here are Oreos, Sprinkles, maybe something about the way that the product is designed, or called.

ETFs are, in my view, and based on our results, are no different from other types of products. You need to make them attractive. How do you make them attractive? Well, if you have an ETF that invests in biotechnological firms related to COVID, let's call it Germ. If it's an ETF that invests in the restaurant business, let's call it Bite. Let's make it attractive. Let's use social media. The fees are not so important. I mean, in a way, you're selling an idea for investors who would like to take a bet on some direction of the market, or direction of an industry.

Back to your question, is this good or bad? We could ask the same question on the shelf of yogurts in the supermarket. Seeing so many types of yogurts, so many niche combinations of flavours. Is this good or bad? It's probably good. There is more choice. Maybe it attracts, but sometimes it's not super healthy. It's almost a value judgment.

Ben Felix: There's these two possible explanations that the proliferation of ETFs is democratizing access to investments, and the other view is that it's a competition for attention. Which of those explanations, or which of those theories better explains what we actually see in ETF markets?

Itzhak Ben-David: Yeah, this is very interesting. It's clear that in the early days of ETFs when we think about broad-based ETFs and potentially smart beta, and maybe some of the sector ETFs, we're talking about democratization. Let me think about the use for institutional investors. Clearly, there is gains from efficiency here. Now, as the industry developed, I said, we see more and more niche ETFs, which seem to appeal to smaller segments of the market. Now, we call these specialized ETFs. These are the sector and industry and those that are based on themes. You would think, or at least potentially, these ETFs appeal to investors' sentiment, rather than to more efficient long-term portfolio hedging, or portfolio minimizing cost of investments.

Cameron Passmore: Based on your research, how would you describe the market for specialized ETFs?

Itzhak Ben-David: Specialized ETFs are those that are – these are about 50% of the entire spectrum. In terms of number of ETFs, these ETFs are actually very interesting. They tend to be relatively small, but they charge relatively high fees. If you think about the US market, as of a couple of years ago, they hold about one-sixth of the assets, but they generate about a third of the fees of the industry. It's relatively high-phase, small assets. They tend to be very concentrated in specific industries, or themes. If you think about real estate, if you could think about vegan food, inflation-related AI, Trump-supporting, etc. They tend to launch in relatively hot topics. Again, back to our joint venture, how do we find the best-performing ETF? Best-performing means that we will need to attract the interest of investors. It needs to be a hot topic.

Now, we observe a very interesting lifecycle. These specialized ETFs tend to launch in niches, or corners of the market that experience very high returns in the earlier 12 to 24 months. Going forward, they actually have disappointing performance. We record about negative 30% over five years. These are alpha, and alpha of negative 30% over the course of five years. These are bad investments. Now, why is that? Well, maybe it was cool to invest in a work-from-home in October 2020, but a year later, it's not such a great investment. In fact, if anyone wants, I can probably help you find a Peloton bike, a used Peloton bike for sale. This is just the nature of investments. Things that are hot today tend to be on average, cooler in the coming months, or coming years.

Now, there are two points to make here. One is you might say, well, these thematic ETFs and sector ETFs maybe are somehow used for hedging. Now, all of us pay for different types of insurance. These insurance contracts for us, the consumers are what we call negative NPV. On your life insurance, on average, you're going to pay more premiums than have receipts. Is this a good investment? Yeah, it is a good investment, because it diversifies our portfolio.

Maybe it's the same thing with ETFs. Maybe investors are willing to accept some low performance for some hedging. The issue is that if this were the case, then we should observe them being agnostic to this low performance. You shouldn't care about this low performance. You know that it's going to be low performance going into the contract, but we actually observed the reverse. We see that investors are super sensitive to performance.

After a good performance of these thematic ETFs, they push more money into them. After a bad performance, they pull money out. This investment performance, or flow performance sensitivity is very high, especially in those thematic ETFs, which tells us that they're probably being used for taking bets. These are more speculation tools. But on average, the trend is down.

Now, you may wonder why do they perform before launch and underperform later? Because before launch, I mean, if you look at the historical indices of these newly launched ETFs, they are pretty impressive. It goes back to our joint venture. When we're looking for a new ETF to invest in, we're just scouting the market, seeing what's all tell, and we maybe identify two or three corners of the market, we define our ETFs. It's going to take us about three to six months to put it on the market. There is a prospectus, there is a comments period.

By the time the ETF is going to be launched, our definition of the ETF, or the subject of the ETF is not going to be as interesting. There might be a new AI. There might be a new, who knows what? By this time, the party is over, right? Some retail investors may still be interested in investing in our ETF. Maybe we're not going to lose money as issuers. From an investor's point of view, this is already the end of the party. This is the end of the high performance. From their own words, it's shedding away the overvaluation.

Now, you could see it in another phenomenon in this specialized ETF. They tend to liquidate more often. If you compare the broad-based ETFs, they are not attempting to generate any alpha. They're not appealing to investors who try to make super strong bets. There are maybe a way to park your money. With the thematic ETFs, they have a very short lifecycle. When you see a new thematic ETF, you should ask yourself, probably, are we at the top of the market now in this particular corner of the market?

[0:16:34] BF: Yeah, that's so good. I love the hedging point that if these were being used as hedging tools, investors would hold them, despite negative returns because that's what they expected. Instead, we see the performance chasing. It's fascinating. Given all that, what do you think someone who has had their attention grabbed by some sector or thematic ETF, what should they be thinking about?

[0:16:56] IBD: Yeah. In general, the advice to retail investors is don't be a retail investor. Try to keep a well-balanced portfolio and not react to every little move in the market. Thematic ETFs appeal to these type of investors who are being driven by sentiment. On average, they are going to lose 30% over five years. The best advice is, of course, I should say, no financial advice. Based on my research, maybe try to avoid these opportunities. If you feel very energized, you may short-sell them. They basically mark the hottest trends.

The way to think about it is there is some overvaluation in a particular corner of the market, you're going to see an ETF coming and offering more of the same thing to investors. If you see that, this is on average, a signal for overvaluation.

Cameron Passmore: If we think about impact on the market, how are ETFs different from other investors, like mutual funds, or hedge funds?

Itzhak Ben-David: The big innovation of ETFs was that it is traded continuously. By comparison, mutual funds are traded – you could place your orders once a day. The mutual fund is going to place, or utilize your funds in the next day, or the next coming days. There is much more synchronous activity in ETFs. Now ETFs are used both by institutional and retail investors. Mutual funds tend to be more retail investors, sometimes through financial advisors.

There is something, I think, in the both fees and speed of ETFs versus mutual funds. Mutual funds seem to be used for short-term bets, because of their liquidity, because of their accessibility. Now, hedge funds are perceived by many as a more long-term investment. Many of them have some liquidity restrictions. You can't invest in and out in a hedge fund. You have to place your money for three, or six, or six months, or maybe a year at least before pulling it out. A hedge fund is more a long-term investment. So are mutual funds. ETFs are used for more short-term bets.

Ben Felix: How does ETF ownership affect the volatility of the underlying securities?

Itzhak Ben-David: Right. The continuous trading of ETFs comes at a price. The reason is that both the ETF and the underlying securities are traded in parallel. You can think about the ETF that trades an index, like the S&P 500. Think about some demand of investors pushing the ETF up. Now, the ETF may rise from the opening of the market until noon, maybe it rises by 1%. But the underlying stocks of the S&P 500 may not have risen so much.

If the ETF wants to trade or to track the index perfectly, then there needs to be some arbitrage mechanism between the two, making the returns of ETF and underlying the same. Because this is what the ETF tries to achieve, mimicking the underlying market, or the underlying index. ETFs do it in two main ways. One is that the ETF itself issues and redeems units. Basically, they approve participants. Some large financial intermediaries may go and collect, in our case, ETFs rose more than the underlying. Some financial intermediaries are going to collect some, buy some shares from the underlying and the ETF for a price, so it's going to be a way for the ETF in a way to expand itself, but in a way moving some of the run-up in its price to the underlying securities.

Another mechanism is just the arbitrage by market, just normal market participants. If I see that the ETF rose more than the underlying securities, maybe there is an arbitrage opportunity here. Maybe I should buy some of the large participants in the S&P 500 and short-sell the ETF. By having these pressures in both directions, it allows the ETF and the underlying securities to have similar returns.

Now, the issue is that ETFs may receive some idiosyncratic demand shocks. Let's assume that maybe someone on social media says, “Let's buy the S&P 500 today.” There are going to be some demand shock unrelated to the economics of the underlying securities. The ETF will rise by the arbitrage mechanism. Also, the underlying stocks will increase. The ETF is a transmission mechanism really between demand shocks of investors to the underlying securities.

Now, this might be perfectly fine if these demand shocks were completely related to the cash flows of these firms. Suppose we say, the US economy is doing great. Let's all buy the S&P 500. This is going to be a very legit way to transfer information. However, as we know, financial markets are noisy, and some of the securities are less liquid. These types of shocks could be transmitted and basically create mispricings. This is what we find in one of our studies, is that ETFs could actually push stocks in one direction, could be up or down, but it's going to be actually a mispricing. There is some random or arbitrary shock to the ETF. There is some arbitrary demand to the ETF. Basically, it's going to push the underlying stocks in the same direction.

Ben Felix: We had a guest tell us a while ago that – the language that he used was that ETFs are a pricing vector for less liquid securities. They're putting information into prices that just couldn't get into the price of the underlying because it's not liquid enough. How do we separate those two hypotheses? How do we know that we're getting noise, as opposed to fundamental information?

Itzhak Ben-David: Right. I should say that they're not necessarily mutually exclusive. You could have an instrument that adds to information, but at the same time increases also noise. These two would increase simultaneously. In the case of our study, we were asking, do they add noise? We have some evidence showing that it does. A key component here is to find a price shock to demand that is unrelated to the fundamental cash flows.

You would like in a way more people to own ETFs that own the underlying shares in a way that is unrelated to the cash flows of these firms. What we're doing in this study, we look at the reconstitution of the Russell 1000, versus the 2000 indices. What happens there is that if you think about the Russell 1000 holding the largest 1,000 shares in the economy, the Russell 2000 holding the next 2,000. Stocks that are around the cut-off, around the 1,000, say, between 950 and 1,050, many of them are going to switch indices at the course of their reconstitution. Their reconstitution happens once a year.

Imagine a stock that is the smallest one on the Russell 1000. It's maybe a stock number 970. This stock has relatively small holdings at the ETF that tracks the Russell 1000. Suppose you didn't perform that well that year, or other stocks perform better, so you can push from 970 to say, 1,050. Okay. Suddenly, you're one of the largest stocks in the Russell 2000. ETF ownership is going to discontinually increase around the reconstitution date.

Suddenly, we have much more ETF ownership. What we see is that these stocks tend to have higher volatility after their reconstitution. These volatility returns tend to revert. These are not permanent changes, but rather volatility that basically reverts. These tend to be noise. Now, as I said, this doesn't mean that there is no more information, probably macro information, because if people trade the Russell 2000, maybe they take bets on the entire economy. Maybe there is more information transmission. At the same time, there is also more noise.

Cameron Passmore: Just to further that a bit, Zahi, how does ETF-related volatility affect the expected returns of stocks?

Itzhak Ben-David: Right. What we observed in our research is that stocks with the higher ETF ownership tend to have higher volatility and higher expected returns. One way to think about it is that this is an undiversifiable risk, that this is how investors perceive this type of volatility. I should say that this area of research, I think, deserves more investigation, because I mean, the impact of ETFs is just phenomenal on the markets. I mean, the markets of today, this year, 30 years into the invention of ETFs is dramatically different than three decades ago. there is a lot to study in this field.

Ben Felix: Fascinating stuff on ETFs. All right, I want to shift to mutual funds, which is also fascinating. What do we know about the behaviour of mutual fund investors?

Itzhak Ben-David: Right. There have been several phenomena, empirical phenomena, things we see in the data that have been documented in the literature. The first one is that we observe investors chasing past returns. Mutual funds that perform the best tend to receive the most flows. Call it return chasing. Performance chase. The second one is that performance usually does not persist. It seems that investors, or money goes after past performance, but this performance, once this money arrives to the fund, it does not persist going forward.

Now, let me also add that the field of mutual funds is very interesting from an academic point of view because it allows us to study how investors place their investment money. I mean, if you think about just the stock market in general, stocks change hands. Whenever you buy a stock, I may be selling. The supply of shares is constant between issuances or repurchases, but it's generally constant. We can see volume. We can see transaction volume, but we don't see an increase in investment on an ongoing basis.

In mutual funds, we can actually see mutual funds contracting and expanding. It allows us a view or a perspective of how investors think, what do they value? For example, thinking about past performance. Do they care about past performance of the last month, or the last year, or the last three years? How do they think about what is important in terms of performance? Now, these two phenomena that I mentioned, chasing past performance and past performance does not predict future performance has basically, multiple explanations. The two interpretations that got the most traction is one that is rational. Investors try to find the best mutual fund manager. They scan the universe of mutual funds, and they find those that perform really well.

I mean, obviously, if you're a good mutual fund manager, you should perform well. They put their money there. But because so much money goes to these funds, basically, they exhaust all the opportunities, all the alpha opportunities. This is what we see. We see money going after good performance and no alpha going forward. This is the Berk and Green 2004 famous paper. It's a theory paper.

Another interpretation is that there is relatively little persistence in general. Investors just chase noise. Some funds do better than others, just because of luck. Think about each fund manager flipping coins and we invest in those that have the longest streaks going forward, doesn't guarantee any persistence. These are just flipping coins.

Ben Felix: It's a big deal, right? Because when we talked to Jonathan Berk a while ago, and we've talked to Ken French, because they have each a big paper on learning side and on the luck side, but has big implications for how we view mutual fund managers. Are they lucky or are they skilled? It's interesting stuff. Of those interpretations of mutual fund investor behaviour, which one makes more sense to you?

Itzhak Ben-David: I'll tell you about the research in a few moments, but my prior coming into this research was that mutual fund investors remind me of some family members. We're just not financial experts. Where do we invest your money? Well, you look at the Wall Street Journal and you find the league table and probably, number one is great. It's probably better than number 10, or a mutual fund that is not on this list, right?

I oftentimes like to think about mutual fund investors as Homer Simpsons, right? These are households. You look for the tastiest donut. How else would you make an investment, right? I mean, some other studies, maybe you could get to them later, think that investors somehow calculate betas and alphas and factor models, etc. Given that most households or individuals can't even distinguish between an index fund and actively managed fund, what do we expect? I mean, how would you hypothesize even, or your prior would be different than investors are just looking at league tables, or looking at past returns?

Just as a tidbit, what I mentioned earlier about a lack of persistence and flows chasing past performance appears not only in actively managed funds but also in index funds. I mean, in index funds, there is no manager. It's just an index. It's similar to ETFs. It basically follows either a sector or the entire market. We see exactly the same phenomena. Investors put more money after good times. Going forward, there is no persistence in this performance.

Ben Felix: Oh, that's interesting. In index funds, there cannot be any learning, because there is no even attempt to –

Itzhak Ben-David: Yeah, a good definition.

Ben Felix: Yeah, that's super interesting. Really interesting.

Itzhak Ben-David: Any explanation on learning needs to find a difference between the behaviour in mutual funds, versus active mutual funds. This is a good litmus test for, is this learning explanation holds order in a way. Interestingly, the studies that you alluded to earlier look at actively managed funds only.

Ben Felix: Yeah, that is interesting. I got to say, too, that in our world of financial advice, I think that this behaviour is even common there in a lot of cases. I've had many conversations with other financial advisors who are supposed to be the professionals. They talk about, “Well, why would I use this index fund for my client when this active fund has outperformed over the last five years? Why wouldn't I just pick the active fund?”

Itzhak Ben-David: Yeah. I mean, why would you want to invest in a fund that lost 20% in the last three years, right? Well, let's say, I must say that even for professors of finance or finance experts, it's just difficult, right? I mean, why would you invest in something that I've showed you already that doesn't generate wealth? It is tough, right?

Cameron Passmore: How can we learn what investors care about from the mutual fund flows?

Itzhak Ben-David: Right. The way to think about mutual fund flows and the information environment, performance being part of it, is almost like horse betting, right? I mean, we have different mutual funds competing for flows. We see investors placing these flows on a monthly basis. We could actually observe which ones appear to be more attractive.

Give one example. Think about two funds. One fund A has an alpha of 5% and a beta of zero. Meaning, whatever the market does, this fund generates 5% every year. Fund B has no alpha, no skill. Basically, gives you the market back. It has a beta of one. Now, suppose last year, the market went up 10%. This means that fund A still generates 5%, regardless of what the market does. Fund B gives you back the market 10%. Let's forget fees. Now, which one do you prefer?

If you're a sophisticated investor, you will say, alpha of five is great, because it's higher than the risk, I’d say. And it's an alpha, right? It's better than what I could get in the bank. It's risk-free, etc. If you're chasing unadjusted returns, you don't understand the whole beta issue, alpha-beta, you will go with fund B, because it generated higher returns. This is a way for us to understand whether investors understand market risk, for example.

Now, you could extend this example also to other types of factors. You could do a three Fama-French factors. You could do four Famas. This is why mutual funds are so attractive. You could run this experiment on names of funds. You could do about the history of the fund. Do investors prefer short history of performance, or long history of performance? It's almost like a good lab to understanding investor preferences.

Ben Felix: When you do it, because you've looked at this, what do the mutual fund investors care about?

Itzhak Ben-David: Oh, it's a great question. It's been a long debate for many years. I stayed on the sideline. There were two famous papers that found that investors chase CAPM, meaning that they care about CAPM alpha, as opposed to unadjusted returns. For me, this didn't square with reality, or the reality I knew with my priors, so I decided to jump in with a group of authors and just study this area.

One way for me to look at data is to look at some statistics, before running any sophisticated econometric specifications, or regressions. If you just look at the data and ask, where do investors make their money? Is it in funds with top Morningstar ratings? The same number of funds with the top alpha, the top unadjusted returns, the top three Fama-French factors, etc. Where do they put their money? You see that through the entire history, you could go back to the 90s with our data, investors place their money where the Morningstars are. In addition, we can talk more about Morningstar, but Morningstar is highly correlated with past performance, unadjusted past performance. No alpha, but rather, raw returns.

Basically, if investors choose between different funds, they go after Morningstar, the highest Morningstar ratings, the highest adjusted returns. If you look at the time series, which month or years we see more inflows to the mutual fund industry, this is going to be about just unadjusted returns. It's not alpha. Alpha is almost zero by definition. When you look at the – like, every month is going to be around zero, it's really about the unadjusted returns. After a good stock market returns, money flows into the stock market. After bad ones, money, there are outflows. We find actually, no alpha chasing, whatsoever. It's all about Morningstar and unadjusted returns.

Ben Felix: That's crazy. To follow on that, what is actually going into the Morningstar ratings that's driving the flows?

Itzhak Ben-David: Morningstar has been around since the mid-80s and became really the industry-dominant rating agent, rating firm since the late 80s, early 90s. It basically generates a rating for each mutual fund that has been around at least three years. The ratings are between one and five stars. In Amazon, what would you prefer? A three-star product, or five? Five, of course, right?

Ben Felix: That's so good.

Itzhak Ben-David: Yeah, it's good right? Five is good. Now, what goes into these ratings? Well, this is actually a very interesting question. It's really past returns. It's some sort of a weighted average of the three-year past returns, five-year and 10-year, depending whether the horizon is there for a specific mutual fund. It has a tiny adjustment for volatility. If you have very volatile returns, you may be penalized by a bit, but it's essentially past returns. This is what we see in data. Investors like four and five stars. The flows into these stars to these mutual funds are positive on average and are outflows from one, two, and three stars on average.

Cameron Passmore: Just to put a point on this, flows that chase returns, or chase ratings are really chasing past performance, chasing returns.

Itzhak Ben-David: This was definitely the case until 2002. Here's what happened in financial markets and in the mutual fund industry. Until 2002, it was very simple. You calculate this weighted average of three, five and 10 years for each fund, you rank all funds in the universe, the top 10% of funds account are five stars, the next 22% are four stars, and then it goes down to three and two and one star.

Now, you can think about the mutual funds themselves. They tend to specialize in particular areas. In particular, they follow styles. Styles are basically a combination in the Morningstar world, a combination between value blend growth and small cap, mid cap, and large cap. You could be one of these nine combinations of these styles. Now, these styles are in the background. If you were a manager in the nineties and you were large in growth, these are the high-tech firms, you did really well, right? I mean, this was a fantastic life to be –

Cameron Passmore: Remember it well.

Itzhak Ben-David: No matter what you touch, you make money, right? Here are four or five stars. Most funds, most managers in these large growths were either four or five stars. Life was really good. The dot-com arrives, dot-com crash arrives 2001. Suddenly, your performance doesn't look that great. You may be a fantastic manager, right? I mean, even within the sector, or with this style, you could be a great manager, but your performance is definitely hurt by the crash of the NASDAQ back then.

Now, these managers, low bid Morningstar saying, “Hey it's not fair. We are great managers. We were four or five stars, tons of flows, managing large funds. Now our star rating plummeted just because the market crashed. I mean, it's not our fault.” Morningstar had a little committee and basically, they decided on reforming the ratings.

Instead of a global ranking across the entire universe, let's now focus within each style. We have nine styles, again, combinations of value, blend growth and small cap, mid cap, and large time. It could be each mutual fund is allocated to one of these styles. The ranking are done within style. Before it was how all the five stars and four stars could have been concentrated in one cell. Now, there are evenly spread.

Now for some managers, this was great news. For others, it was less good. Ben, let's think that you're a large growth, or you're a fund manager in a large growth fund. I'm a fund manager in a small cap value fund. Let's assume that both of us have the same mediocre talent. We're not so good, not so bad. You are really lucky, because your style, large growth did really well in recent history. You enjoy four stars. I'm also a mediocre manager, but small value didn't do that well. Because it’s my fault. Just the style itself, the stocks in this corner of the market didn't do that well, so I’m at one star.

Now, instead of comparing us, we are two different styles, we're going to be benchmarked against other managers within our style. You're going to be compared to other managers of major funds that are investing in large and growth stocks. I will be compared to a separate group of managers who are specializing in small end value. Now, because we are both mediocre within our groups, your ranking is going to go down from four to three. Mine are going to increase from one to three. Both of us are going to have three stars.

Now, what does it mean for flows? If investors chase Morningstar ratings, before the change, you were four stars, you would get tons of flows. I would probably get outflows, because I was one star. Now, we get the same amount of flows, probably slightly negative.

Ben Felix: Makes perfect sense. That's a total rewiring of the Morningstar rating system. We've talked earlier about the importance of Morningstar ratings on flows. What was the impact of the change on flows?

Itzhak Ben-David: It's very interesting. It went unnoticed. Five stars are five stars. It's the same with Amazon, right? I mean, did we ever notice that Amazon modifies the way it calculates its stars?

Ben Felix: It went unnoticed in the sense that investors still chase star ratings.

Itzhak Ben-David: Oh, yeah. For sure. Five stars is five stars, no matter how it is calculated. It's the same with the Amazon products. Suppose Amazon implements a change to its ratings, right? Instead of just taking a simple average, maybe it gives more weight to recent ratings, or ratings from the US versus the rest of the world, or around your location, relative to the rest of the world. For the consumers, it's probably not going to make a big difference. Five stars is five stars. I don't know exactly how they calculate their stars. It seems like an average of some sort.

If it changed, I'll still pursue the high number of stars, right? Flows just went as witnessed before. Now for managers, it made a big difference. For mutual fund managers, if you were in a style that on average did really well, like in the 90s, the large and growth and later other styles, you were used to receiving tons of flows. It's not only you, it's all the mutual funds in your style, or most of the mutual funds in your style. This rewiring basically shifted flows around.

Before, if you think about before 2002, flows naturally just aggregate. Just sum up all the flows across funds. They went to the best-performing style on average. Within the style, the best-performing managers. If you think about styles, they went basically to the best styles. I want to say best styles. The styles with the best past performance.

Now, after the reform, all styles have five-star managers within them. All styles have four stars and three stars and one star. The number of stars, or distribution of stars is going to be the same within each group, each style. Flows are going to spread like butter on a piece of toast. Going to be evenly across all different styles.

Now, what's interesting here is that flows in general have a market impact. Flows, think about what a fund manager who receives flows do with these flows. Well, you just go and buy more of the same stuff. You manage a lot of growth, you receive a bunch of flows at the beginning of the month, you turn to the market and just buy more of the same stuff that you already own. You're boosting your own portfolio in a way, inadvertently. If everybody does it within your style, and all of us are buying large growth, it's going to boost this niche, these underlying securities.

Okay, so there is going to be some sort of momentum built in when there are flows concentrated in a relatively small area and style. Once flows are spread across the universe, in a way, we don't have this concentrated price pressure on a particular niche of the market. The monies are changed, seems like a relative small change. It's like, just, let's look instead of ranking mutual funds across the entire market, let's just do it within style. It seems like a very small – maybe it's a one line of code in their system. It actually had a fundamental change on markets by reallocating flows across all styles, instead of one style.

Ben Felix: That's crazy. Flows go from chasing styles to chasing managers. What impact does the change have on the time series and cross-sectional variation of style returns?

Itzhak Ben-David: What we observe in our work is that prior to 2002, there was a lot of continuation, both in flows and in returns. You can think about a fund that did really well has very high ratings, attracts more flows. These flows basically are put to work in the market in the same style, pushing style returns even more. Your rating is doing really well. Your performance is really good, etc. This is a positive feedback loop that Morningstar's reform basically broke. We stopped seeing this positive feedback, both in flows and in returns.

Coincidentally, momentum stopped working around this period. This has been documented in other work. We see that there is basically no momentum going forward in style returns. We see also, that the dispersion of returns, the return performance is much lower. Before, if the style did really well, got much more flows, which continues. The dispersion between styles was much bigger. After, it just compresses. At the same time, there is a higher co-movement across styles, because styles now are governed by the same flows, the same, typically, inflows to this market.

Ben Felix: Are you saying the momentum died after 2002, and it was caused by this?

Itzhak Ben-David: Momentum died after 2002 in the US. This has been documented by other studies. What we find is that the Morningstar change was a prime contributor. It may not be the only one. I mean, it's difficult to rule out that there were other ones. The nice thing about the Morningstar change is that we have a date for this change. In June 2002. We could really go with a microscope around 2002 and see what happened to momentum portfolios. We see that basically, they stopped working around this date.

Now, I should say, the world is a very noisy place. This was a very turbulent period. It was the recession. When you look historically, sometimes it's difficult to identify precisely. But here, there is a date, right? Let's say, you could actually go and see. It's actually not just momentum itself. It's also other factors that are related to momentum. Think about industry momentum. Think about 52-week high, other factors that depend on past prices, these top two almost disappear.

Ben Felix: Yeah, that's crazy. I guess, that means that using backtests to look at momentum strategies pre-2002 is a bit dicey, maybe.

Itzhak Ben-David: Yeah, momentum – well, backtesting in general is notorious, right? Yeah, momentum doesn't work. Interestingly, in other stock markets where the change didn't care, momentum keeps on going. Not as strong as before, but it keeps on going. I wouldn't be surprised if there are other contributors to this change, but it seems that the Morningstar is a prime one.

Now, I should say, more generally, it's just fascinating to me how asset prices that we oftentimes think about as driven by cash flows and risk and risk sharing is driven by simple things, like ratings and changes things.

This wasn't a government policy, or it's just a decision of a small group of people in the private firm, making a small decision. This wasn't their intention of making these changes. Just made sense to them to make the decision just because of fairness of mutual fund investors. It had such a profound impact on the way we look at asset pricing and factors and how we think investors price rates. Probably they don't price rates that much. They just react to these returns and to these factors. Overall, it highlights the importance of what is called now demand-driven asset pricing and just institutional frictions in the way that asset prices are being set.

Ben Felix: That's crazy. There's risk-based explanations for asset pricing. There's investor behaviour explanations. Is institutional frictions another contributor to asset prices?

Itzhak Ben-David: Yeah. I have no doubt that this is the case. It's obviously not instead of other explanations. In asset pricing, in general, it is difficult oftentimes, to pinpoint a specific explanation. You find correlations, think about liquidity, for example, right? You could find more liquid, less liquid. It's difficult to find a cause and effect. This actually just happened to be a case where you could actually pinpoint to the specific effect. You could actually trace the flow. You could trace the specific funds. You have a date. It's pretty unique in this respect. Again, it's not the only factor, but it seems like institutional and structural factors are important ones in determining asset prices.

Ben Felix: That's a really cool experiment to use that change. You mentioned hedge fund investors earlier when we were talking about – you mentioned how they're different from mutual fund and ETF investors. Can you talk more about how the behaviour of hedge fund investors is different from what we just talked about with mutual fund investors?

Itzhak Ben-David: Yeah, for sure. Mutual funds have a special status, because they appeal to many investors, unlimited number of investors. Because of that, they have also limitations. They, oftentimes, [inaudible 0:53:05], they cannot take a leverage. They cannot enter into short positions. They cannot engage in derivative markets. They're pretty limited in what they can do.

Hedge funds are the private version, where you're allowed to recruit up to 99 investors called limited partners. They have to show that they are sophisticated investors. That they know what they're doing. They have enough wealth. In return, the hedge fund itself can be a bit – not a bit. Sometimes a lot more aggressive. It can use derivatives. It can take short positions. It could use leverage. Now, what's interesting is that even though we're looking at two separate groups of investors, households in mutual funds versus sophisticated investors in hedge funds, we observe very similar performance. We see a pattern, empirical patterns. One is performance chasing. The other one is a lack of persistence. Maybe there is a bit, but it's definitely not justifying the performance chasing that we observe.

When we think about the investors themselves in hedge funds, you can think about university endowments. You can think about pension funds. You can think about insurance companies. Typically, these are professional investors in family offices. These tend to be professional investors who look at the performance of the hedge fund and decide to invest. Usually, these are large amounts of money being invested in each hedge fund. The entire performance chasing is a bit strange. Why would you always put your money in the best-performing one? If you understand financial markets, you know that much of it is luck, much of it is noise. This is strange, but this is what we see in the data.

Cameron Passmore: Can you give us a quick rundown on the difference in fees between typical mutual fund and a hedge fund?

Itzhak Ben-David: Yeah. In mutual funds, managers charge a percentage of AUM assets under management. It could be 1%, 1 bit, maybe slightly below 1. In mutual funds, there's been a historically common contract called two and 20. You charge 2% on AUM on your assets under management. These are just to keep the lights on, they say. Then there is 20% that is paid for a performance. If I perform well, I'll get 20%. This has been since the first hedge fund in the late 40s, they say. It persists until today. Now, in reality, sometimes it's not 2 and 20. It might be 1.7 and 15%, or 1.5 and 25%. Two and 20 is really the most common, even if we look at the entire range of mutual funds.

Ben Felix: How does the two and 20 structure typically work out for end investors?

Itzhak Ben-David: The two and 20 are calculated basically every period. Typically, every year, sometimes every quarter. You're going to pay your 2% on the amount that you invested and then 20% on the profits that I made. Now, when we look at the data, we actually see that over a long period and we talk about 22 years of data, we see that actually, investors paid 50% of their profits to investors. Instead of 20% in the contract, 50% went to investors.

Ben Felix: That's crazy. Sorry, it's supposed to be two and 20, is the number everyone's heard from upfront, but they're actually paying –

Itzhak Ben-David: Yeah. I should say, everything is legal. They pay two and 20. In actuality, it becomes 50. The reason for this is the asymmetry built into this contract. I want to give two examples that maybe will square these facts. Think about holding two hedge funds in your portfolio. You’re a large investor, you invest in two hedge funds. You had a mediocre year. One fund made money, the other one lost, let's say, the same amount. You're still going to pay fees on the gains you made, but you're not going to get your money back, or you're not going to get a rebate from fund B.

Overall, maybe you didn't make money during this year. On top of this, you paid 20% on the gains that one of them made. This is in the cross-section, right? These are in a portfolio of funds. Think about holding one fund now over time. Suppose there is one year where the fund makes money, I'm paying fees along the way, as every year I'm paying fees. At some point, the fund may lose money. I'm not going to get my fees back.

Now, investors oftentimes are protected by what is called high watermark provision, which means that I will not pay additional fees until my losses are being recovered. Now, the issue is that, oftentimes, investors remember they are chasing past returns. I will enter a fund after gains. Suppose, the fund makes money, that's great. I'm going to keep on paying my 20%. If at some point, and most funds at some point lose money, at least temporarily, at this point, I'm not going to get my fees back.

Also, what we see in the data is that investors are more likely to exit the fund at this point. Because I'm disappointed. Maybe I lost 15% this year. I'm saying, “Ah, the fund is no longer good. Maybe there is another fund.” Okay. I think about the example of going from 100 to 150, I'm paying fees along the way. Then it goes back to, say, 120, I'm disappointed. Taking my money out. But I paid fees along the way from 100 to 150.

Now, we see also another phenomenon in the data is that managers are more likely to liquidate their funds after deep losses. Again, think about the manager managing a fund going from a 100 to 150, collecting fees. Now, suppose that we had terrible two years’ worth. Instead of 150, where it’s 70, okay. In order to start gaining fees, I need to at least manage my funds to a 150. Maybe it's better for me just to close down my fund and do something else with my life.

Both investors’ return chasing and fund liquidations actually exacerbate this phenomenon. When you just look at the data, this 2 and 20 becomes 2 and 50. 50% of the profits go as an incentive fees. If you combine both management fees and incentive fees, you're looking at close to 65% of profits going to hedge fund managers. You know how they say, what are the odds of the investors in hedge funds? It's always better to be the hedge fund manager.

Ben Felix: That's wild. There's a cross-sectional issue, where if you as an investor hold two funds, a winner and a loser, you can't net out performance. You end up worse off there. Then there's also a time series issue, where people chase performance, or funds close down and you lose your high watermark credits.

Itzhak Ben-David: Exactly.

Ben Felix: Wild.

Itzhak Ben-David: It is interesting. An interesting question is, do investors anticipate this kind of behaviour? It's really difficult to know, right? I mean, we're talking about sophisticated investors. We know that some of them actually stopped investing in hedge funds. CalPERS is known as an investor who stopped investing in hedge funds in 2014, I think. Other investors seem to be content. It's really difficult to know what are the expectations. I wish we ran a survey in 1995 and asked investors, what do you expect to pay on these hedge funds, as opposed to what you expect to receive? If you have a time machine, send me there. Send me to the 1990s.

Cameron Passmore: What tends to happen after investors pull their money away from a hedge fund after a loss?

Itzhak Ben-David: You might say, well, maybe it makes sense for them to – who cares about the loss fee credits, as long as I don't lose more money, maybe I'm okay to put my money after a loss. Well, what we see in the data is that actually, there is very little predictability. After pulling money out of hedge funds, actually, the returns, they have no memory. They tend to be slightly better after times that investors actually put money into hedge funds.

Now, these are average results. It's difficult to make specific recommendations. I think for many investors, it's just difficult to know that you keep investing in a fund that may lose. Just psychologically difficult. Maybe if you sleep better at night, maybe it's okay. In any case, you lose your fee credits, which again, exacerbates this phenomenon that you're leaving more money on the table, or not in the table, in the pockets of managers.

Ben Felix: You're giving up the fee credits that have a relatively known value, I guess, but you're not avoiding sure losses, which is what people may be imagining they're doing.

Itzhak Ben-David: Exactly. Exactly.

Ben Felix: So interesting. A lot of the times, when I tell people about this, I mean, about your paper specifically, and I think one of our past guests, Ludovic Phalippou, has looked at this for private equity as well, or similar stuff for private equity. The common response is that, well, if you end up in a good fund, you're happy to pay performance fees. I got to ask, how well did the hedge fund incentives fees correlate with hedge fund performance? Are investors getting the performance for their performance fees?

Itzhak Ben-David: Right. In our sample, the performance is very close to low single-digit, these are averages. Now, what we see is that investors, as you said, these are averages and not risk-adjusted. Now, investors pay incentive fees to managers based on an annual basis, without seeing the future. I wish we could see the future. I mean, we have the luxury of looking back and seeing the lifetime performance of hedge funds.

Now, if you think about the difference between two and 20 and two and 50, there are 30% there, 30% of profits that didn't go by definition to pay for profits. They were either offset by other losses, or lost later. We call this 30% unjustified incentive fees. Again, in retrospect. We see that these fees are basically spread across the universe of performance. Many funds, or a good fraction of funds end up with complete losses through their lifetime. They still collect the same amount of unjustified fees as well-performing funds. These unjustified fees are basically spread across the universe and are about 1% of management fees.

One way to think about it is that when I'm investing in a hedge fund, there is this friction. There’s 30% that I'm going to pay on profits that I will eventually lose somehow, or are going to be offset by losses. They amount to about 1% of AUM. They are like an additional management fee that I take. Hedge funds are an expensive way to manage your money at the end of the day.

Cameron Passmore: Just to wrap up this section, what are the main lessons for investors who might be considering allocating to hedge funds?

Itzhak Ben-David: Yeah. You would think that after so many years of investment hedge funds by sophisticated investors, there would be some contracts that will work for everybody. One solution is the fee clawback. Think about this fund that made money one year and loses the next. Suppose you could get your money back, your fees back, instead of using this high watermark, so this is going to be a solution. The solution of clawback is actually, does it work across funds, right? I mean, if we have fund A and fund B, fund A makes money, fund B loses money, we can’t ask for a clawback from a fund that never received any fees. This is a partial solution.

I think, the other takeaway is that even for professional managers, intuition could be misleading. The big claim of hedge funds, oftentimes, is that we get these incentive fees to make us work harder to find alpha opportunities. Don't worry, we get paid when you make money. This is true for every particular hedge fund. But in aggregate, this is not true. Your intuition may work for this particular contract, but if you look at the portfolio, it doesn't work anymore. I think this is actually, there are maybe other aspects in our lives where every particular decision may look, makes sense, but if you look at the entire picture, it may not. Intuition doesn't always work. I think this is the takeaway.

Ben Felix: Yeah. It’s so good. That paper is just incredible.

Itzhak Ben-David: Thank you. If you want to be the editor of my journal, I'll – You got a job.

Ben Felix: The headline of that paper is crazy, like the 50% thing. But read through the methodology and why it's true, it's just one of those things. It's the exact way you just said that intuition just doesn't capture that stuff.

Itzhak Ben-David: Yeah. Maybe I will add to this that these are just speculation, right? We don't have any formal evidence for this. Hedge funds are just in many organizations, part of the portfolio of illiquid assets. I think about the theory, or the way things are being done in endowments and pension funds. I mean, you keep part of your portfolio in liquid stuff. Some of it is in illiquid stuff. You don't ask too many questions about the fees that are less important maybe. You just see the annual results. You see them at a very low frequency, so you don't know exactly how volatile they are. It's just part of the way we do things, right?

We don't ask too many questions about why we do them, or do they make sense, or just part of this inertia, I think, that happens sometimes in markets, or in the way that we do things in general.

Ben Felix: Yeah. All right, I want to switch gears to another paper that is just so interesting, and so relatable. I mean, I'm sure listeners will be able to relate to it once we get into it. The topic is how people treat their tax refunds. How do people treat their tax refunds differently from their other income and expenses?

Itzhak Ben-David: Yeah. We all love tax refunds, right? I mean, because one day, maybe around April or May, you have another half salary in your account. It's great. This is what we see people do in the data. People generally spend this money. They go more to restaurants. They have more money in their checking account. They also save a bit of it, but they almost treat it like a lottery, if they don't understand that it came from their own hard work and from their own deductions from last year. We see them consuming more and saving part of it.

Now, what's interesting about it and the reason we started looking into tax refunds is because tax refunds are the same as tax payment, just with a different sign. People seem to treat them completely differently. With the tax refund, people just go and spend mainly on short-term consumption. It's like, restaurants. Some of it may go towards durables. It's almost like my secret saving that comes to my checking account once a year. But a lot of it goes to just, let's go and celebrate. There is some money in the checking account.

Tax payments are considered outside of my income cycle. I will pay for my tax payment from my savings. I'm not going to skip a restaurant this month in order to fund my tax payment. This asymmetry between these two is what really caught our attention.

Cameron Passmore: What do all these results tell us about mental accounting?

Itzhak Ben-David: Mental accounting is a behavioural theory, originally proposed by Richard Thaler, who got a Nobel Prize, who was my advisor at the University of Chicago. In a paper with Shefrin from 1988, they proposed a behavioural lifecycle model. It's actually a model that I find very relatable to the way I observe other people and the way that I manage my own finances. Basically, in this model, they are in our heads. There are two entities. There is a doer and there is a planner.

The doer is really positive, wants to consume, wants everything now. Think about it as present bias. I don't care about the future. I just want to have fun now. The planner is thinking about the future. Now, the issue is that the dodoeror is the one that actually does the actions. It's the impulsive one. The planner can only set the rules in a way. The planner doesn't tell me how to conduct my day-to-day life. How does the planner restrict the doer? The planner does it by setting up some rules. The rules are, for example, you can spend on day-to-day consumption, think about restaurants or perishables, out of your savings. It's only in extreme cases that you do that. It's only your current income, your checking account that could be used for day-to-day expenses.

However, these are big expenses; fixing the roof, a tax payment. Okay, these are outside the labour income cycle. This should go from other sources. Think about spending income from different sources. How would we think about spending $1,000 coming from labour income, a lottery, or an increase in our house value? Rational theory will tell you they're all the same. They're all $1,000. Doesn't matter where it comes from.

Mental accounting will tell you, well, they will have different uses in a way. In a way, we're earmarking our income and matching uses to the source of income. From rational theory, a dollar is a dollar, no matter where you got it. People will assign different uses to these funds from lottery versus income versus increase in the house value. What we see here with the tax refunds is that actually, people think differently about refunds and payments.

With refunds, I'm going to increase my consumption. I'm going to eat more. With payments, I'm not preventing food from my kids, but rather, I'm taking it from my savings. Although, essentially, these are really the same things. Tax refunds and payments are basically just adjustments to what I paid in Texas last year.

Ben Felix: If this is a mental accounting issue, what can people do to avoid splurging their tax refunds?

[1:12:09] IBD: Oh, it's a great question, because it can make a difference to many people. You can think about different solutions. One solution is to not to get it directly. Once it is in my checking account, it is just destined to be eaten. One way to do that is just think about your planner. Just avoid bringing it to my checking account. In the US, for example, you could instruct the IRS to buy government bonds with your tax refunds. Basically, don't get it, or part of it you're not going to get it. You're going to get bonds. In a way, it makes it illiquid. It helps saving it.

Another way could be just to minimize your deductions in the previous years. In a way, we're finding ways to trick the doer in our mind. As soon as it hits my checking account, I have an agreement with myself that it all goes to saving, for example. I just try to not treat it as a windfall, but rather, understand that this is destined towards savings.

Ben Felix: Yeah, great topic. We've got one more topic to cover to finish up our conversation here. You've got a couple of just phenomenal papers on this idea of miscalibration. I love these papers. Can you talk about what miscalibration is?

Itzhak Ben-David:Yeah. These papers are part of a broader literature of behavioural biases, behavioural economics. In behavioural economics, we think about biases from rational thinking. There are many different biases. The two that we're thinking about often in either household finance, or financial markets, or behaviour of managers, executives, as we have in this case, are optimism and overconfidence.

One way to think about these is basically, these are first and second moments in predicting future outcomes. Optimism is going to be being overly optimistic about the outcome. The outcome might be sales of my firm next year. Overconfidence is about the distribution of outcomes. Obviously, sales next year could have a distribution that could be good, bad, or maybe in the middle. Overconfidence, I'm just too sure of my forecast.

In the literature of psychology, people think about three types of overconfidence. One is called better than the average. This matches to this survey question, are you better than the average driver? The answer is, of course, and others are morons. It turns out that 80% of people think that they are better than the average. This is one type of overconfidence. The second type of overconfidence is called illusion of control. Things happen in the world. Oftentimes, we attribute these things that happen outside to our own decisions. This was a great decision for me to invest in the stock market. See? the stock market went up 10% last year. Obviously, if I lost money, it's somebody else's fault, not mine.

The third one is miscalibration. Miscalibration is really an over-estimation of my own ability to make forecasts. Oftentimes, people ask in the context, not in the financial context, in order to measure overconfidence, people ask a series of questions. The goal in these questions is going to get 80% of them correct, let's say. This is going to be an 80% confidence interval. These type of questions might be, for example, what is the distribution of the New York Times? When was the black play? For each question, you would give me some range. It happened between these years and these years, say, the distribution of the New York Times, between this number and this number. The goal of this game is to get 80% of the answers within the range.

Now, as it turns out, most people are miscalibrated. They give you a too narrow interval. They're too confident in their own estimate. This is the background. Now, you could see how this type of bias is so important in the corporate world, right? I mean, in order to advance in the ranks, you'd better be a good manager. Good manager, meaning taking good decisions, deciding on the right advertising campaign and closing sales. By being bold and being confident in your estimates, you're more likely to succeed.

Now, oftentimes, I mean, other people have shown in the research, past successes are attributed to people who have been advanced. I don't know whether you noticed, I have a slight accent. Not everybody can notice it. I'm originally from Israel, and there is this saying of who becomes the chief of staff in the military, although they took risks and we're lucky not to be killed in the battlefield. It's the same thing. You’re a risk taker, you don't realize that you're taking risks and you happen to survive, you climb the ranks.

Cameron Passmore: You studied the calibration of CFOs. How well-calibrated are the return expectations of CFOs?

Itzhak Ben-David: Yeah. In this work, we had access to survey, the trend for since the year 2001. We basically asked CFOs to predict the S&P 500 returns one year ahead and provide an 80% confidence interval. Basically, telling us there is one intent chance the realized return is going to be above this number and what is the number for which one in 10 times it’s going to be below? Basically, asking for an 80% confidence interval.

Now, what we see in the data is that only about 35% of the time the realized SLP returns after a year actually hit this confidence interval. What it means is that CFOs gave us, instead of an 80% confidence interval that we asked, they gave us a narrow confidence interval of about 35%. Now, it may look counterintuitive. Any idea of what is the confidence interval of the S&P 500? If I ask you, take your prediction, say, 8% next year, plus-minus what will make 80%?

Ben Felix": I don't know. Off the top of my head – don't know.

[1:18:37] IBD: Oh, so you're under-confident. It's plus, minus 20%. This is based on historical data. This generates about 80% confidence interval. In the data, we actually see that it's plus-minus 7%. It's just too narrow. Instead of plus-minus 20%, I would probably say less, if I had to. But, plus-minus 20% seems freely wild. Yeah, but stock market returns are pretty into out of 10 years, you get returns that are either above 20%, or below negative 20%. As I said, this goes for a very long time. You could look at any period in these 22 years of data that we have. On average, it's 35% of the time they're right, instead of 80%.

Ben Felix: Wow. How does CFO miscalibration respond to market uncertainty, or rising market uncertainty?

Itzhak Ben-David: When markets are more uncertain, think about high VIX, for example, you would anticipate that the confidence interval is going to be wider. I mean, if I ask you in March 2020, what do you think about next year? The world could be either – the economy is going to be driven to the ground, or maybe there is a rebound. Who knows? No. But what we see is that actually, the response of CFOs is asymmetric. They think a lot about the downside and less about the upside.

During times of very high VIX, we get a very negative lower bound. Things could be really bad by the end of next year, but we see less of an upside. It seems, I think, a way of or representative of how people think, especially in stressful situations, they just extrapolate. Things would be really bad next year. Yeah, maybe good, but certainly there is a potential for a downside.

Cameron Passmore: Do CFOs become better calibrators as they produce more forecasts?

Itzhak Ben-David: In this study, we have the privilege of serving the same people again and again and again. Some of them go for 20, and sometimes even 30 quarterly forecasts. We have the same forecast from the same people. What we see is that miscalibration and the size of this confidence interval is more or less constant per person. If you tend to give us relatively narrow forecast, say, plus, minus 5% for next year, and you just keep on doing that, it seems that there is very little learning, if any. Just keep on doing this plus, minus 5%, maybe expand, or contract depending on the economy. If you started with plus, minus 15%, you're going to just continue this trend.

Now, interestingly, we also see that people will stay with us for longer time, tend to give us wider confidence intervals. Maybe it's because the confidence interval itself tells something about just personal trade tells you something about who you are, or so we see this in data.

Ben Felix: That's really interesting. Last question on this section, what do you think are the main lessons that investors can take away from CFO miscalibration?

Itzhak Ben-David: CFO miscalibration seems like an inherent characteristic of one's personality. It's really difficult to work against. Now, ways to overcome it are really to use tools, or to use decision support tools, to use data. If before asking you the question, I would tell you the question about the S&P. We tell you, well, here's the historical distribution of what happened in the last 50 years. What do you think now? Well, obviously, I cannot give you the answer, but you can think about this as a way to help people make decisions. We're talking about hedge fund investment earlier.

If you told your clients, four out of five, suppose these are numbers. Three out of five investments in hedge funds end up in losses, is this really interesting for you? Maybe you help decision maker, whether this is an investor, or executive, or just household, you help them with data. I think this is what could help.

Ben Felix: That's nice. Yeah. Basically, base rates, right?

Itzhak Ben-David:Yeah, absolutely.

Cameron Passmore:Amazing. Our final question for you, Zahi, how do you define success in your life?

Itzhak Ben-David: Thank you. Thank you for this question. This question actually was the topic of dinner conversations at my household for a few nights. I have four kids, ranging between ages 10 and 21. We had a conversation about success and goals. My kids reminded me that I oftentimes told them, move gentle. You should work as hard as you can until you fail. Then you know that you succeeded.

If I try to generalize this, success really depends on the goals you set to yourself. In an absurd way, you know you work to the max and probably succeeded once you start seeing failures. Until then, things are probably too easy for you. This is what I try to preach and try to live by. Sometimes more successful than other cases. Yeah, so success sometimes could be failure.

Ben Felix: That's a really, really cool answer to the question.

Itzhak Ben-David: Is it the coolest one that you received from? No, I’m just kidding. Of course.

Ben Felix: No, we've had however many hundred or whatever, but it's a unique answer. I can say that.

Itzhak Ben-David: All right. Thank you so much.

Cameron Passmore: Ben's going to give you a high cool rating for having four children.

Ben Felix: Yeah. I've got four kids, too. Awesome. Great answer to the question. This has been a fantastic conversation. We really appreciate you coming on.

Itzhak Ben-David: Thank you so much. It's been a pleasure.

Is there an error in the transcript? Let us know! Email us at info@rationalreminder.ca.

Be sure to add the episode number for reference.