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The ETF market has experienced significant growth, with thousands of ETFs available worldwide. The industry has evolved from broad-based ETFs to more specialized ones that cater to specific niches and investor preferences. New products are constantly introduced, targeting unique themes and industries. While ETFs are seen as a way to democratize investments and provide more choice for investors, there is evidence that specialized ETFs tend to underperform over time.
ETFs can impact the volatility and pricing of underlying securities due to their continuous trading and arbitrage mechanisms. When demand shocks occur, ETFs can transmit those shocks to the underlying securities, causing mispricings. This effect is particularly pronounced in specialized or thematic ETFs. The continuous trading of ETFs creates opportunities for arbitrage, allowing the ETF and underlying securities to have similar returns. However, the proliferation of ETFs and their ability to transmit investor sentiment can result in increased volatility and mispricing in the underlying securities.
Investors in both mutual funds and hedge funds exhibit similar behavioral patterns, such as performance chasing and lack of return persistence. Mutual fund investors tend to chase past returns and often allocate their investments based on short-term performance. Hedge fund investors, despite being considered sophisticated, also display these behavioral biases. Moreover, hedge funds tend to charge high fees, with investors paying a significant portion of profits in fees. This suggests that investors should be cautious when considering hedge fund investments and carefully evaluate the value provided by the fees they are charged.
Investors tend to base their investment decisions on Morningstar ratings and unadjusted returns. They prioritize funds with higher Morningstar ratings, even though the ratings are primarily based on past returns. This preference for ratings over other factors, such as alpha and adjusted returns, has a significant impact on flows in the mutual fund industry. The reliance on Morningstar ratings leads to concentrated flows into certain types of funds, boosting their underlying securities and creating price pressures in specific areas of the market. The Morningstar rating system underwent a reform in 2002, which resulted in a more even distribution of stars across styles. This change effectively spread flows more evenly across different fund styles, reducing the concentration of flows and the impact on specific segments of the market. Additionally, the reform had a significant and lasting impact on momentum strategies, with momentum losing its effectiveness as a predictive factor after 2002.
People tend to treat tax refunds and tax payments differently due to mental accounting biases. Tax refunds are often viewed as windfalls and are predominantly used for short-term consumption, such as dining out and other discretionary expenses. On the other hand, tax payments are typically seen as separate from regular income and are often financed from savings rather than reducing current spending. This asymmetry in behavior between refunds and payments highlights the role of mental accounting in shaping spending decisions. To avoid splurging tax refunds, individuals can take measures such as diverting the refund into savings or setting agreements with themselves to prioritize saving over immediate consumption. It is important to recognize these biases and develop strategies to make more informed spending decisions.
For nearly 25 years, Exchange Traded Funds (ETFs) have been a popular passive investment vehicle for both household and professional investors due to their low transaction costs and high liquidity. But what are the pros and cons? How can you diversify your portfolio to avoid volatility? Today, we are joined by Professor Itzhak Ben-David, one of the world’s foremost academic experts on ETFs, 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 current ETF market and the impact that ETFs have on underlying securities and investor outcomes. We discuss Morningstar ratings, the change that happened in 2002, and some mind-blowing data regarding hedge fund fees. We also dive into the correlation between miscalibrated CFOs and overconfidence; the unnecessary mental accounting people do when it comes to 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 at the household level. Finance experts will certainly find value here, too! 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.
Links From Today’s Episode:
Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582. Rational Reminder Website — https://rationalreminder.ca/
Shop Merch — https://shop.rationalreminder.ca/
Join the Community — https://community.rationalreminder.ca/
Follow us on X — https://twitter.com/RationalRemind
Follow us on Instagram — @rationalreminder
Benjamin on X — https://twitter.com/benjaminwfelix
Cameron on X — https://twitter.com/CameronPassmore
Cameron on LinkedIn — https://www.linkedin.com/in/cameronpassmore/
Itzhak Ben-David — https://u.osu.edu/ben-david.1/
Itzhak Ben-David on LinkedIn — https://www.linkedin.com/in/ibendavi/
Financial Markets and Human Behavior - https://bpb-us-w2.wpmucdn.com/u.osu.edu/dist/d/7877/files/2023/08/202308_Rational_Reminder_podcast.pdf
‘Do ETFs Increase Volatility?’ – http://ssrn.com/abstract=1967599
‘Mutual Fund Flows and Performance in Rational Markets’ – https://ssrn.com/abstract=383061
‘The Performance of Hedge Fund Performance Fees’ – https://ssrn.com/abstract=3630723
‘Paper on how people treat their tax refunds’ — https://doi.org/10.1111/j.1540-6261.2007.01232.x
‘Managerial Miscalibration’ — http://ssrn.com/abstract=1640552
‘The Persistence of Miscalibration’ — https://ssrn.com/abstract=3462107
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Listen to the best highlights from the podcasts you love and dive into the full episode