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Saturday, 17 July 2010

Behavioral Law and Disorder

Mutual Fund Perfection

It’s may come as a surprise to you that the mutual fund industry, at least in the United States, is a shining record of fiduciary duty. It’s a fact that not once in twenty-five years did a shareholder in one of these funds manage to convince a court that their money has, in any way whatsoever, been mismanaged. This is despite a raft of allegations, originally stemming from the investigations of the ever-vigilant, if nocturnally over-enthusiastic, ex-Attorney General of New York, Elliot Spitzer, that many of the advisors running these funds had deliberately siphoned profits from long-term individual shareholders to institutional clients.

However, a recent judicial decision moves the goalposts – it’s no longer theoretically impossible for a private shareholder to successfully sue a mutual fund. No, now it’s actually impossible. The reason for this is grounded in an economic theory of the marketplace that is dying everywhere else: the idea that markets are perfect. It’s time for a little behavioural law and order.

One Law for Lawnmowers and Mutual Funds

Corporate law reflects the prevailing models of economics and it’s unsurprising that it does so, but as we’ll see it also implies a nasty bout of circularity in reasoning. Traditional law and economic models uphold the principle that the price of an item is determined, efficiently, by the market. So, in principle, if someone pays too much for their lawnmower that’s not regarded as a matter for the law unless the thing goes haywire and shreds your Schnauzer and busts-up your backyard.

Applied to lawnmowers this makes some level of sense, but applied to mutual funds – or investments of any kind – it’s an argument that recent behavioral research calls into question. As the failures of all attempts to sue mutual funds shows it also represents an almost insurmountable barrier for plaintiffs. Basically if the price of a security is always correct by definition then it’s impossible for a shareholder to sue successfully.

Free Markets, No Law

As Lawrance A. Cunningham explains the current legal position in “Behavioral Finance and Investor Governance”:
“The market for corporate control should be unburdened by rules of timing, disclosure, payment or other tilts in the playing field. Fiduciary duties could be relied upon in quite weak forms to police those rare managers who somehow escape the clutches of market discipline to act contrary to the corporation’s and shareholder’s interests … Concern over the type and timing of company disclosure, and even the principles of accounting applied in preparing financial statements, could be limited since the activity of the efficient market and its participants will pierce these, getting at the real truth and reflecting it in market price.”
This is the law. Anyone still believe economic models don’t matter?

This isn’t only about the prices paid but also covers the fees for mutual fund shareholders. Investor advisors generally run two sets of funds – one for institutional clients and one for the rest of us. We pay more in fees despite the existence of legislation supposedly protecting us from unfair pricing. Yet as stated previously, no shareholder has ever won a suit and the SEC has never bothered bringing a case before the courts.

Legal Brawl

So far so bad. But now an unseemly brawl has erupted between two of the pre-eminent experts in law and economics which has led to the Supreme Court taking an interest. It’s a straight fight between traditional, efficient market economics on the one hand and behavioural finance on the other. There are a lot of mutual fund fees riding on this decision.

The problems have arisen over a case – Jones v Harris Associates L.P. – where Judge Frank Easterbrook has handed down a decision that one of his colleagues, Richard Posner, has dissented from in a very vociferous manner. The case is essentially about whether excessive fees were charged or not and based on previous cases the appellant didn’t have really have a leg to stand on. In fact it’s a wonder why they bothered and after the original finding they were probably wishing they didn’t and wondering why they didn’t have any limbs left at all.

In essence Easterbrook overturned the previous case law – known as Gartenburg. As William A. Birtwhistle’s Investment Indiscipline: A Behavioral Approach to Mutual Fund Jurisprudence explains:
“[Easterbrook ] presumed a well-functioning market for investment advice, discounted possible irrational investor behaviour and concluded with a call for greater deregulation of the industry. “[We] are skeptical about Gartenburg because it relies too little on markets,” he announced””.
There’s a clear summary of the legal problems with this judgement in Emily Johnson’s The Fiduciary Duty in Mutual Case Excessive Fees.

No Professional Help Here

The finding is that competition sets the appropriate level of remuneration for advisors and, in a free functioning market, this can’t be wrong. Unfortunately even if this was correct – and most behavioural finance research would call it into question – it’s not clear that the market for mutual funds is free functioning for individual shareholders.

In most markets inexperienced and na├»ve investors can expect a helping hand from professional and informed ones. Notwithstanding that these groups have different priorities and that the latter are often just as subject to behavioural flights of fancy as the former it’s possible to see that in a well functioning market it’ll be the professional investors that set the price of securities and, therefore, the price of these will often be roughly efficient. This is why the price of smaller securities which attract little professional interest can often diverge dramatically from their real value for a long time.

Institutional Favouritism

However, in the mutual fund world professional investors have their own set of funds subject to their own, lower, set of fees. Small shareholders get no free-ride in this world and can express their satisfaction or otherwise with fees and prices only by buying or selling themselves – which they all too often get wrong. So even if we argue that the fees and prices associated with common stocks are efficient there’s no automatic read-across to those of private investor mutual funds. Which is, in effect, what the dissenting opinion from Posner has argued.

In the meantime, however, a separate court finally handed down a judgement in favour of a plaintiff, dismissing arguments that the differences in fees between institutional and private investors was due to the greater costs of advising the latter. This, if supported by the Supreme Court, puts the whole industry in some danger – if the price dispersion, aka the failure of the Law of One Price, seen across the industry and supposedly caused by different levels of service is put under the legal microscope we’re likely to see a wave of litigation, or a sudden drop in fees. It may also put excessive executive compensation squarely in the sights of lawyers.

Paternalism or Freedom

Easterbrook’s opinion – which had the misfortune to be published on the eve of the crash of ’08 – stated that:
“No matter how poor or weak the results produced by the free market may be, alternatives – particularly those championed by governmental authorities – are sure to be worse”.
This position of course is a statement of free-market economic orthodoxy. Analysing standard economic models one’s almost compelled to the position that these are often not descriptions of the way the world’s financial systems work but justifications of it. If that’s true then the adoption of these approaches by the legal system is a based on a completely circular argument.

Modifying this position to include behavioural theories would push us towards a paternalistic model where governments aim to nudge us in directions that are in our best interests. Whether that’s better or worse depends upon your personal view: we’d better hope that the new models of behaviour law and order are better than what we’ve been used to.

Related articles: Survivorship Bias in Magical Mutual Funds, Jack Bogle and the Bogleheads, Momentum Trading Madness


  1. “No matter how poor or weak the results produced by the free market may be, alternatives – particularly those championed by governmental authorities – are sure to be worse”.

    The contest is not between free markets and government-controlled markets. The contest is between old ideas about how markets work and new ideas about how markets work.

    There is no such thing as a free market without free speech. Markets work through the spread of information. When the spread of accurate information is prohibited, the idea that the market in which this prohibition takes place is free becomes a myth. Our stock market is not today a free market. I know from personal experience that the penalties imposed on those who offer accurate information can be severe, severe enough to stop most who are aware of the realities from speaking up.

    The problem is a political one at this point. As a society we need to move to make information about how markets work more readily available to those participating in the market. But, as this case shows, there is a great institutional interest in blocking the spread of good information. And the political reality is that those seeking to block the spread of good information are 50 times more intense than those favoring free speech.

    The encouraging news is that the economic crisis is gradually changing that. A deepening of the crisis may provide us with the political courage we need to take the steps needed for us to overcome the crisis. That's my prayer, in any event!


  2. Deep appreciation for one of the most intelligent and interesting blogs on the web.
    Thank you/

  3. “No matter how poor or weak the results produced by the free market may be, alternatives – particularly those championed by governmental authorities – are sure to be worse”.

    I wish that if our courts are to keep rewriting laws based on this sort of casuistical argumentation, that they would admit that is what they are doing.

    Better yet: that they to acknowledge how shallow and ill-informed their logic is.

    This statement is political; the "justification" for it is based on faulty reasoning. While the field of "Behavioral Economics" may be young, the existing "Efficient Markets" literature relies on clearly-stated postulates that the court here is asserting are always true. In real Finance, the postulates are taken as helpful assumptions that establish how markets are efficient, and which markets, lacking the assumptions, could be inefficient.

    One of the five (IIRC) important postulates is that short-selling is possible; that is obviously incorrect for mutual fund pricing.

    I.e., the court is claiming theoretical finance as justification for its political positions, but that theory relies on assumptions that are not true for this market.

    These court decisions are just blatantly false. They may also be woefully unjust.