[The power of the behavioral component in most human activities cannot really be dismissed, especially as drawn out in today’s current pandemic and economic crisis environment. We are seeing otherwise termed “rational” people be driven by fear, uncertainty, confusion, and anxiety.
To better explore and understand the behavioral effects on investing, we decided to go to the veritable source of this topic Fuller & Thaler Asset Management – a firm that has pioneered the application of behavioral finance in investment management by combining cognitive psychological theory and conventional finance. The firm was built by what has been recognized as the founders of the fields of behavioral economics and finance - Dr. Russell Fuller (Founder, CIO, and Graham & Dodd AIMR award from the CFA Institute), Dr. Richard Thaler (Founder, Principal, 2017 Nobel Prize for Economic Sciences), and Dr. Daniel Kahneman (2002 Nobel Memorial Prize in Economic Sciences and author of Thinking Fast & Slow). Not resting on their laurels, the firm was named as a Finalist for 2020 Asset Manager of the Year by Envestnet and Investment Advisor Magazine that recognizes high-conviction portfolio managers that exemplify investment management best practices.
We spoke with Fred Stanske, CFA Portfolio Manager of the Fuller & Thaler Behavioral Small-Cap Growth Fund (FTXSX) to provide us with more perspective and context on their investment philosophy and process.]
Hortz: What do you see as being the major sources of alpha and their relative benefits for investment managers?
Stanske: To generate alpha, an investment manager must have some sort of advantage, or edge, over their competition. The two most common claims lie in having either better information (Information Edge) or better analysis (Analytical Edge).
Generating alpha via better information implies that the information collected is either better than what others have access to, or altogether different information than what others are looking for. To have an Information Edge, an investment manager must know something that others do not – which in today’s connected world is incredibly difficult.
More recently, due to the increase in the speed and access to information, many traditional investment managers seek an Analytical Edge. That is, while the information gathered is the same, it is processed better, or differently in order to gain an advantage.
At Fuller & Thaler, we think we have pretty good analysis capabilities – but one of the lessons of behavioral finance is to beware of confirmation bias – that you are not as smart as you think you are. So instead, we rely on having a Behavioral Edge. Our non-quantitative, event-driven, rules-based approach is designed not only to avoid, but to capitalize on the behavioral mistakes that other investors make. Investors make mistakes because they have emotions, use imperfect rules-of-thumb, and have priorities beyond risk and return. At Fuller & Thaler, we look for those mistakes.
Hortz: Is there research or data that proves a relative benefit and why do you think behavioral sources seem to be more effective?
Stanske: Our behavioral approach works because we exploit the mistakes made by other investors, the overwhelming majority of whom employ a fundamental investment approach. Fundamental investors inevitably fall prey to the human biases of over-confidence and anchoring, and this leads them to under-react to situations where new information undermines their existing assumptions. This type of under-reaction stems from innate human psychology and has been well-documented by behavioral finance scholars for decades in top tier journals like The Journal of Finance.
Hortz: Why then are the majority of managers not using a behavioral investment methodology?
Stanske: Equities represent ownership stakes of listed companies, and as such, their value will be driven by investors’ forecasts of businesses’ future cash flows and/or their estimates of the net asset value of these businesses. Naturally, the vast majority of investors will try to make these forecasts and estimates based on their fundamental analysis, and almost all active investing in the stock market will be driven by this fundamental analysis. This has always been true and will continue to be true in the future. However, this basic fact creates an opportunity for Fuller & Thaler’s behavioral investment approach, which exploits the psychologically driven errors made by these fundamental investors.
How and why the efficient markets hypothesis took hold in academia and investment manager training probably has more to do with the idiosyncrasies and unique dynamics of academia than anything else—a subject that is beyond the scope of our investment process and probably irrelevant to it.
Hortz: How are these sources of alpha and different methodologies holding up in the current market and economic disruptions we are dealing with?
Stanske: The plunge we saw in the stock market earlier this year, the big rally that immediately followed it, and the extreme volatility we have seen throughout shows that nobody really knows what’s going on with the pandemic and the economy in the short-term. There’s a difference between reading a lot about the pandemic and being able to consistently predict short-term moves in the stock market based upon what you’ve read, but that is a distinction that many traders don’t seem to grasp. Our behavioral investment approach, which avoids short-term speculation and typically employs longer term holding periods, has generated alpha through a full range of macroeconomic conditions. We expect that to continue in the future.
Hortz: Your flagship strategy and one of your mutual funds, the Fuller & Thaler Behavioral Small-Cap Growth Fund (FTXSX), are Small Cap Growth portfolios. You have applied your behavioral methodology in other asset classes, but is there something specific to that universe that seems to work best or is inducive to a behavioral approach that made you start there?
Stanske: It is possible that smaller-cap stocks are more prone to mispricing because of their relative lack of attention from investors creates greater market inefficiencies around them. This premise is what led Fuller & Thaler to focus exclusively on small-cap stocks in its early days. While investors make mistakes in asset classes of all types and sizes, we believe they make even more mistakes in small-cap stocks. Why? Besides receiving less attention, there are four times more small-cap stocks than large-cap stocks—providing four times the opportunity set.
Hortz: Can you walk us through the particular dynamics of how you apply your behavioral investment methodology in the small cap growth area?
Stanske: Our investment process is based on decades of research into behavioral finance.
Behavioral finance is the study of how investors actually behave, as opposed to how they should behave, when making investment decisions. Professional investors are human, and like all humans, they make mistakes. Investors make mistakes because they have emotions, use imperfect rules-of-thumb, and have priorities beyond risk and return. We look for those mistakes. We predict when other investors – the “market” – have likely made a behavioral mistake, and in turn, have created a buying opportunity.
Our funds target stocks that are either underreacting to good news or overreacting to bad news. The Fuller & Thaler Behavioral Small-Cap Growth Fund (FTXSX) is in the first category. Instead of looking for stocks that are about to move higher, we want companies that are already rising because of developments like strong earnings or new products but have much further to go.
We are actually buying the news of the positive information and we're actually selling it when the analysts or the market participants have caught up to that news or new information about the company.
The key to that is finding stocks where analysts are too slow to update their estimates and opinions once that good news arrives. That makes them "biased forecasters," and it can be a sign of opportunity in the stock. If expectations are stubbornly low, the company should beat them repeatedly, leading to long-term gains.
The next quarter, you are going to see a positive earnings surprise, or sales surprise. And this will go on for a number of quarters until the analysts actually catch up.
Hortz: Is there anything particularly timely about the small cap area at this juncture?
Stanske: As you know, although small-cap stocks have historically outperformed large-cap stocks by a significant margin, small-cap stocks have underperformed large-caps for a while now: the Russell 2000 index has returned 8.25% in the last five years vs. 13.67% for the S&P500. If one expects small-caps to eventually revert to their pattern of outperforming their larger-cap peers, then investing in them now, after this long period of underperformance, would be a good idea.
In the near-term, small-caps have underperformed large-caps partly because investors have sought the safer havens of established large-cap companies whose business have been less affected by the pandemic and are viewed as likely to survive the pandemic. If you believe that the market will eventually anticipate the end of the pandemic and the start of a global economic recovery, it would not be unreasonable to expect small-caps to outperform in such a market environment. If we look back over the last 15 recessions since 1926, a recent analysis found that small cap stocks have outperformed large caps by 3.9% in the second half of a recession and by 15.8% in the year following a recession (1). We think it is a great time for investors to consider rebalancing their portfolios which naturally means selling things like large cap growth and FAANG stocks that have gone up the most and investing in smaller cap stocks that still represent potentially better value.
Hortz: Any final advice on how you would recommend advisors employ behavioral finance and your funds for their client portfolios?
Stanske: The most common piece of feedback we receive from investors is that Fuller & Thaler’s investment approach is unique and significantly different from the fundamental and quantitative approaches used by other managers. For investors looking for a manager whose investment methodology complements those of their other investment strategies and whose investment track record shows substantial long-term alpha across several investment strategies, Fuller & Thaler could be an ideal choice.
(1) Center for Research in Security Prices (CRSP®), The University of Chicago Booth School of Business; Jefferies