Several studies have shown investing anomalies that can’t be rationally explained by the efficient market hypothesis. Behavioral finance attempts to fill the void by explaining behaviors that shouldn’t exist. I propose a new area for research for behavioralists.
There have been many studies demonstrating that money flows follow performance, meaning that investors put their money into funds and sectors that have performed well recently. It also means investors pull their money from poor performers. This unfortunate behavior has been one of the causes of the well-documented phenomenon of investor returns being well below their very own funds. There appears to be a major exception to this rule: Despite the poor and inconsistent performance of alternative investments, investors continue to pour cash into them.
According to Morningstar, investor flows into alternative investments reached $14.7 billion in 2010, up from $10.8 billion in 2009 and just $3.4 billion in 2008. And the flows as of mid-year show that they’re on pace to match 2010’s total this year. Clearly this is a big trend.
Given the flows, you would think that the returns have been spectacular, and you would be dead wrong. As you consider the data, keep in mind that this three-year period 2008 through 2010 includes the period from July 2008 through February 2009 when the S&P 500 Index lost 41.5 percent, the very period when “alternatives” are supposed to provide risk protection. The figures represent the total return for the three-year period.
* Represented by MSCI indexes
The following represents the total return for international indices for the same period:
- MSCI EAFE Index — -3.8%
- MSCI EAFE Value Index — -3.4%
- MSCI EAFE Small Cap Index — 11.2%
- MSCI Emerging Markets Index — 14.2%
Clearly, any well-diversified portfolio would have outperformed all of the alternative strategies.
As I discuss in The Quest for Alpha, the long-term evidence on alternatives such as hedge funds is no better. Thus, the only explanations I can think of for the continued rush by investors to pour money into alternatives are:
- Investors are unaware of the evidence.
- While their performance is awful, the marketing machines of Wall Street are so good that they can overcome even this powerful evidence.
But perhaps the behavioralists will provide us with some alternative explanations for this bizarre and self-destructive behavior. Before you consider becoming a member of the “alternative investments club,” remember Groucho Marx’s famous line: “I don’t want to belong to any club that would have me as a member.”
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