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

29:46Going forward, it doesn't guarantee any persistence. These are just flipping coins. It's a big deal, right? Because when we talked to Jonathan Burke a while ago, and we've talked to Ken French, because they kind of have each a big paper on the learning side and on the luck side, but it has big implications for how we view mutual fund managers. Are they lucky? Are they skilled? It's interesting stuff. Of those interpretations of mutual fund investor behavior, which one makes more sense to you? 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 some family members.

30:22You know, we're just not financial experts. Where do you invest your money? Well, you know, 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 in this list. Right. I oftentimes like to think about mutual fund investors as Homer Simpson. Right. I mean, these are households. You look for the tastiest donut, or how would you make an investment, right? I mean, some other studies, and maybe we could get to them later, think that investors somehow calculate betas and alphas and factor models, et cetera.

30:57You know, given that most households or individuals can't even distinguish between index fund and actively managed fund, what do we expect from them, right? 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.

31:40We see exactly the same phenomena. investors put more money after good times going forward, there is no persistence in this performance. Oh, that's interesting. So in index funds, there cannot be any learning because there is no even attempt to it. Yeah, that's super interesting. Really interesting. So any explanation on learning needs to find difference between the behavior in mutual funds versus active mutual funds. So this is kind of a good litmus test or is this learning explanation holds order in a way. And interestingly, the studies that you alluded to earlier look at actively managed funds only.

32:17Yeah, that is interesting. I got to say too, that in our world of financial advice, I think that this behavior is even common there in a lot of cases. Like I've had many conversations with other financial advisors who are supposed to be the professionals and they talk about, you know, 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? Yeah. I mean, why would you want to invest in a fund that lost 20 % in the last three years? Let's say, I must say that even for professors of finance or finance experts, it's just difficult, right?

32:54I mean, why would you invest in something that I've showed you already that it doesn't generate wealth? It is tough, right? I mean. How can we learn what investors care about from the mutual fund flows. Right. So 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. And we see investors placing these flows on a monthly basis. So we could actually observe which ones appear to be more attractive. So give one kind of example. So think about two funds. And one fund A has an alpha of 5 % and a beta of zero.

33:39So meaning whatever the market does, this fund generates 5 % every year. Fund B has no alpha, no skill. Basically, it gives you the market back. So it has a beta of one. Now, suppose last year, the market went up 10%. So 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? So if you're a sophisticated investor, you will say alpha of five is great because it's higher than the risk-free rates A. And it's an alpha, right? It's better than what I could get in the bank, it's risk-free, et cetera.

34:21If 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. So 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 three farm French factors, you could do four farm. This is why mutual funds are so attractive You could run this kind of 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?

35:01It's almost like a good lab to understanding investor preferences. So when you do it, because you've looked at this, what do the mutual fund investors care about? Oh, it's a great question. So 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 unjust returns. And for me, this didn't square with reality or the reality I knew with my priors. So I decided to kind of jump in with a group of co-authors and just study this area. And one way for me to look at data is look at summary statistics.

35:44before running any sophisticated econometric specifications or regressions. If you just look at the data and ask, where do investors pay their money? Is it in funds with top Morningstar ratings, the same number of funds with the top alpha, the top unjusted returns, the top three Fama-French factors, et cetera? Where do they put their money? You see that through the entire history, if you go back to the 90s with our data, investors place their money where Morningstar stars are. And in addition, Morningstar, we can talk more about Morningstar, but Morningstar is highly correlated with past performance, unadjusted past performance.

36:29So no alpha, but rather raw returns. So 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 good stock market returns, money flows into the stock market. After bad ones, money, there are outflows.

37:06So we find actually no alpha chasing whatsoever. It's all about Morningstar and unadjusted returns. That's crazy. So to follow on that, what is actually going into the Morningstar ratings that's driving the flows? Right. So Morningstar has been around since the mid 80s and became really the industry dominant rating agent rating firm since the late 80s, early 90s. And 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. And like in Amazon, what would you prefer? A three-star product or five? Five, of course, right?

37:51That's so good. Yeah, it's good. 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 on whether the horizon is there for a specific mutual fund. It has a tiny adjustment for volatility. So if you have very volatile returns, you may be penalized by a bit, but it's essentially past returns. And this is what we see in data. Investors like four and five stars. So the flows into these stars, to these mutual funds, are positive on average, and are outflows from one, two, and three stars on average.

38:36So just to put a point on this, flows that chase returns or chase ratings are really chasing past performance, chasing returns. So this was definitely the case until 2002. So 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, by count, 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.

39:22And 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. So you could be one of these nine combinations of these styles. Now, these styles are kind of in the background. So if you were a manager in the 90s, 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. Remember it well. No matter what you touch, you make money, right? You're four or five stars. Most fund, most managers in this large growth were either four or five stars.

40:07Life 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 this sector or 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 lobbied Morningstar saying, hey, you know, it's not fair. We are great managers. We were four or five stars, tons of flows managing large funds. And now our star rating plummeted just because the market crashed. I mean, it's not our fault. And Morningstar had a little committee and basically they decided on reforming the ratings.

40:50So instead of a global ranking across the entire universe, let's now focus within each style. So we have nine styles, again, combinations of value, blend growth, and small cap, mid cap, and large cap. So it could be each mutual fund is allocated to one of these styles. And the ranking are done within style. So before it was how all the five stars and four stars could have been concentrated in one sale. Now they are evenly spread. Now, for some managers, this was a great news. For others, it was less good. So Ben, let's think that you're a large growth or you're a fund manager in a large growth fund.

41:41and I'm a fund manager in small cap value fund. And let's assume that both of us have the same kind of mediocre talent. So we're not so good, not so bad. But you are really lucky because your style, loud growth, did really well in recent history. So you enjoy four stars. I'm also a mediocre manager, but small value didn't do that well. Not because of 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. So now, instead of comparing us, we are two different styles. We're going to be benchmarked against other managers within our style. So you're going to be compared to other managers of mutual funds that are investing in large and growth stocks.

42:33I will be compared to a separate group of managers who are specialized in small and value. Now, because we are both mediocre within our groups, your ranking is going to go down from four to three, and 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 will get tons of flows. I will probably get outflows because I was one star. Now we get the same amount of flows, probably slightly negative. Makes perfect sense. So that's like a total rewiring of the Morningstar rating system.

43:20And we've talked earlier about the importance of Morningstar ratings on flows. What was the impact of the change on flows? So it's very interesting. It went unnoticed. So 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? It went unnoticed in the sense that investors still chased star ratings. Oh, yeah, for sure. Five stars is five stars, you know, no matter how it is calculated. It's the same with the Amazon products. You know, so 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.

44:08For 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? So flows just went as business before. Now for managers, it made a big difference, right? For mutual fund managers, If you were in a style that was, on average, did really well, like in the 90s, the larger 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.

44:48So this rewiring basically shifted flows around. right before if you think about before 2002 flows naturally just aggregate you know just sum up all the flows across funds they went to the best performing style on average and within the style the best performing managers but if you think about styles they went basically to the best styles i should say best styles the styles with the best best performance now after the reform all styles have five stars managers within them all styles have four stars and three stars and one star right so the number of stars or distribution of stars is going to be the same within each group each style so flows are going to spread like butter on a piece of toast right going to be kind of evenly across all different styles now what's interesting here is that flows in general have a market impact.

45:51So 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 large 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. So 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 are going to be some sort of momentum built in when there are flows concentrated in a relatively small area in style.

46:33Once flows are spread across the universe, in a way, we don't have this concentrated price pressure on a particular niche of the market. So the morning start change seems like a relatively small change, right? It's like just, you know, let's look instead of breaking mutual funds across the entire market, let's just do it within style. Seems like a very small, you know, 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. Yeah, that's crazy. So flows go from chasing styles to chasing managers.

47:18What impact does the change have on the time series and cross-sectional variation of style returns? So what we observe in our work is that prior to 2002, there was a lot of continuation, both in flows and in returns. So 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. So this is a positive feedback loop that Morningstar's reform basically broke. So we stopped seeing these positive feedback, both in flows and in returns.

48:08And coincidentally, momentum stopped working around this period. This has been documented in other work. So we see that there is basically no momentum going forward in style returns. And 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. So the dispersion between styles was much bigger. After, it just compresses. At the same time, there is higher co-movement across styles, because styles now are governed by the same flows, the same typically inflows to this market. So are you saying that momentum died after 2002 and it was caused by this?

48:58So 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. So we could really go with a microscope around 2002 and see what happened to momentum portfolios. And 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 a recession.

49:36So when you look historically, sometimes it's difficult to identify precisely. But here, there is like a date, right? Let's say you could actually go and see. And 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 stop to work or almost disappear. Yeah, that's crazy. So I guess that means that using backtests to look at momentum strategies pre-2002 is a bit dicey, maybe. Yeah, momentum. Well, backtesting in general is notorious, right? But yeah, momentum doesn't work.

50:18Interestingly, in other stock markets where the change didn't occur, momentum kind of keeps on going. Not as strong as before, but it keeps on going. So I wouldn't be surprised if there are other contributors to the 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 kind of driven by cash flows and risk and risk sharing is driven by simple things like ratings and changes. things. And this wasn't like a government policy or it's just a decision of a small group of people in a private firm making a small decision.

51:01This 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. And it had such profound impact on the way we look at asset pricing and factors and and how we think investors price risk. Probably they don't price risk that much. They just react to these returns and to these factors. So it overall 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. That's crazy. So there's like risk-based explanations for asset pricing.

51:40There's investor behavior explanations. Is institutional frictions another contributor to asset prices? 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 to a specific explanation. You find correlations. Think about liquidity, for example, right? I mean, you could find more liquid, less liquid. So it's difficult to find a cause and effect. This is 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.

52:23You have a date. So it's pretty unique in this respect. And again, it's not the only factor, but it seems like institutional and structural factors are important ones in determining asset prices. 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 behavior of hedge fund investors is different from what we just talked about with mutual fund investors? Yeah, for sure. So mutual funds have a special status because they are appealed to many investors, unlimited number of investors.

53:01And because of that, they have also limitations. So they oftentimes, In general, because 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 kind of the private version where you're allowed to recruit up to 99 investors called limited partners. And they have to show that they are sophisticated investors, that they know what they're doing, they have enough wealth. And in return, the hedge fund itself can be a bit, not a bit, sometimes a lot more aggressive. It can use derivatives.

53:37It could 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 kind of 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.

54:14So typically, these are professional investors in family offices. So 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. And the entire performance chasing is kind of a bit strange, right? I mean, 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. So this is kind of strange, but this is what we see in the data. Can you give us a quick rundown on the difference in fees between typical mutual fund and a hedge fund?

54:50Yeah. So in mutual funds, managers charge a percentage of AUM assets under management. Could be 1%, one bit, maybe slightly below one. 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. And then there is 20 % that is paid for a performance. If I perform well, I'll get 20%. So this has been since the first hedge fund in the late 40s, they say. And 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%. but two and 20 is really the most common, even if we look at the entire range of mutual funds.

55:47How does the two and 20 structure typically work out for end investors? So the two and 20 are calculated basically every period, typically every year, sometimes every quarter. So 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, I'm talking about 22 years of data, we see that actually investors paid 50 % of their profits to investors. So instead of 20 % in the contract, 50 % went to investors. That's crazy. Sorry. It's supposed to be two and 20 is the number everyone's heard for head I should say, everything is legal.

56:33They pay$2.20, but in actuality, it becomes$50. And the reason for this is the asymmetry built into this contract. So I want to give two examples that maybe will kind of square these facts. So think about holding two hedge funds in your portfolio. You're a large investor, you invest in two hedge funds. You had a kind of a mediocre year, okay? 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 FundB. So overall, maybe you didn't make money during this year.

57:15And on top of this, you paid 20 % on the gains that one of them made. But this is kind of 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. 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.

58:02So I will enter a fund after gains. Okay. Suppose the fund could use and makes money. That's great. I'm going to keep on paying my 20%. But 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. And 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, but 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.

58:42I'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. So again, think about the manager managing a fund going from 100 to 150, collecting fees. Now, suppose we had terrible two years, instead of 150, we're at 70. In order to start gaining fees, I need to at least manage my fund to 150. So maybe it's better for me just to close down my fund and do something else with my life. So both investors' return chasing and fund liquidations actually exacerbate this phenomenon.

59:31And when you just look at the data, this 2 in 20 becomes 2 in 50. So 50 % of the profits go as an incentive fees. And if you combine both management fees and incentive fees, you're looking at close to 65 % of profits go to hedge fund managers. You know how they say, where are the odds of the investors in hedge funds, right? It's like, it's always better to be the hedge fund manager. That's wild. So 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. So you end up worse off there. And then there's also a time series issue where people chase performance or funds close down and you lose your high watermark credits.

1:00:12Exactly. Wild. It is interesting. And an interesting question is, do investors anticipate this kind of behavior? And 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. But other investors seem to be content. So 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?

1:00:48If you have a time machine, send me there. Send me to the 1990s. So what tends to happen after investors pull their money away from a hedge fund after a loss? You might say, well, maybe it makes sense for them. Who cares about the lost fee credits? As long as I don't lose more money, maybe I'm okay to pull my money after a loss? Well, what we see in the data is that actually there is very little predictability. So 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. So now these are average results.

1:01:25It's difficult to make specific recommendations, but I think for many investors, it's just difficult to know that you keep investing in a fund that made a loss just psychologically difficult. So maybe if you sleep better at night, maybe it's okay. But in any case, you lose your fee credits, which again, exacerbates this phenomenon that you're leaving more money on the table or not on the table in the box of matters. So 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. Exactly. Exactly.

1:02:01So interesting. A lot of the times when I tell people about this, about your paper specifically, And I think one of our past guests, Ludović Falapu, has looked at this for private equity as well, or similar stuff for private equity. But the common response is that, well, if you end up in a good fund, you're happy to pay performance fees. So I got to ask, how well did the hedge fund incentive fees correlate with hedge fund performance? Like are investors getting the performance for their performance fees? Right. So in our sample, the performance is very close to low single digit. These are averages.

1:02:35Now, what we see is that investors, I should say, 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 lifetime performance of hedge funds. Now, if you think about the difference between 2 % and 20 % and 2 % 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. So we call these 30 % unjustified incentive fees, again, in retrospect.

1:03:16And we see that these fees are basically spread across the universe of performance. So 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. So these unjustified fees are basically spread across the universe and are about 1 % of management fees. So one way to think about it is that when I'm investing in hedge fund, there is this friction, this 30 % that I'm going to pay on profits that I will eventually lose somehow or are going to be offset by losses. and they amount to about 1 % of AUM.

1:04:00So there are like additional management fee that I pay. So hedge funds are an expensive way to manage your money at the end of the day. So just to wrap up this section, what are the main lessons for investors who might be considering allocating to hedge funds? Yeah, so 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. So one solution is the fee clawback. So 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 these high watermarks.

1:04:36So 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 ask for a clawback from a fund that never received any fees. So this is kind of a partial solution. I think the other takeaway is that even for professional managers, intuition could be misleading. So the big claim of hedge funds oftentimes is that we get these incentive fees to make us work harder to find alpha opportunities. And don't worry, we get paid when you make money. So this is true for every particular hedge fund.

1:05:18But in aggregate, this is not true. So your intuition may work for this particular contract, but if you look at the portfolio, it doesn't work anymore. And I think this is actually, there are maybe other aspects in our lives where every particular decision may look, kind of make sense. But if you look at the entire picture, it may not. So intuition doesn't always work. I think this is the takeaway. Yeah, that's so good. That paper is just incredible. Thank you. If you want to be the editor of my journal, I'll be safe. You got a job. The headline of that paper is crazy, like the 50 % thing, but to read through the methodology and why it's true, it's just one of those things.

1:06:06It's like exactly what you just said, that intuition just doesn't capture that kind of stuff. Yeah. And maybe I will add to this that these are just speculation, right? So we don't have any formal evidence for this. But hedge funds are just, in many organizations, part of the portfolio of illiquid assets. 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 illiquid 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.

1:06:42You see them at a very low frequency. So you don't know exactly how volatile they are. and 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. 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. So the topic is how people treat their tax refunds. So how do people treat their tax refunds differently from their other income and expenses?

1:07:19Yeah. So we all love tax refunds, right? I mean, one day, maybe around April or May, you have another half salary in your account. So it's great. And this is what we see people do in the data. So 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. Like if they don't understand that it came from their own hard work and from their own deductions from last year. So 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.

1:08:08And people seem to treat them completely differently. So with the tax refund, people just go and spend mainly on kind of 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. But tax payments are considered kind of outside of my income cycle. I will pay for my tax payment for my savings. I'm not going to skip a restaurant this month in order to fund my tax payment. So this asymmetry between these two is what really caught our attention.

1:08:52So what do all these results tell us about mental accounting? So mental accounting is a behavioral theory originally proposed by Richard Taylor, got a Nobel Prize, was my advisor at the University of Chicago. And in a paper with Sheffrin from 1988, they proposed a behavioral lifecycle model. And 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. So basically in this model, there are in our heads, there are two entities. There is a doer and there is a planner. The doer is really impulsive, wants to consume, wants everything now, think about it as kind of present bias.

1:09:37I 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 doer 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. So how does the planner restrict the doer? The planner does it by setting up some rules. So the rules are, for example, you can't 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. So, it's only your current income, your checking account that could be used for day-to-day expenses.

1:10:32However, these are like big expenses, fixing the roof, a tax payment. Okay, these are kind of outside the labor income cycle. These should go from other sources. Think about spending income from different sources. How would we think about spending$1 ,000 coming from labor 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. It 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 kind of earmarking our income and matching uses to the source of income.

1:11:20From rational theory, a dollar is a dollar, no matter where you got it. But people will assign different uses to this funds from lottery versus income versus increasing 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, right? I mean, tax refunds and payments are basically just adjustments to what I paid in Texas last year.

1:12:02So if this is a mental accounting issue, what can people do to avoid splurging their tax refunds? Oh, it's a great question because it can make a difference to many people. So you can think about different solutions. One solution is to not get it directly, right? Once it is in my checking account, it is just destined to be eaten, right? So one way to do that is just think about your planner. Just avoid bringing it to my checking account. So in the US, for example, you could instruct the IRS to buy government bonds with your tax refunds. So basically, you don't get it or part of it you're not going to get, you're going to get bonds.

1:12:46So in a way, it makes it kind of illiquid. It kind of helps saving it. Another way could be just to minimize your deductions in the previous years. So in a way, we're kind of finding ways to trick the doer in our minds, right? I mean, just to, or 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 kind of destined towards savings. Yeah. Great topic. We've got one more topic to cover to finish up our conversation here. So you've got a couple of just phenomenal papers on this idea of miscalibration.

1:13:29I love these papers. Can you talk about what miscalibration is? So these papers are part of a broader literature of behavioral biases, behavioral economics. So in behavioral economics, we think about biases from rational thinking, and there are many different biases. But the two that we're thinking about them often in either household finance or financial markets or behavior of managers, executives, as we have in this case, are optimism and overconfidence. And one way to think about these is basically these are like first and second moments in predicting future outcomes. So optimism is going to be being overly optimistic about the outcomes.

1:14:13The outcome may 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. So overconfident, I'm just too sure of my forecast. And in the literature of psychology, people think about three types of overconfidence. One is called better than the average. And this kind of matches to this survey question. Are you better than the average driver? The answer is, of course, I am. The others are morons. And it turns out that 80 % of people think that they are better than the average.

1:14:50So there's one type of overconfidence. The second type of overconfidence is called illusion of control. So things happen in the world and oftentimes we attribute these things that happen outside to our own decisions. But this was a great decision of 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. And the third one is miscalibration. Miscalibration is really an overestimation 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.

1:15:34And the goal in these questions is going to get 80 % of them correct, let's say. So this is going to be an 80 % confidence interval. So these type of questions might be, for example, what is the distribution of the New York Times? When was the black plate? And for each question, you would give me some range. You know, it happened between these years and these years. The distribution of New York Times is between this number and this number. And 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.

1:16:12They're too confident in their own estimate. So this is kind of 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. And 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 notice I have a slight accent.

1:16:54Not everybody can notice it, but I'm originally from Israel. And there is this saying of, you know, who becomes the chief of staff in the military? It's all those who took risks and were lucky not to be killed in the battlefield. So 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. You studied the calibration of CFOs. How well calibrated are the return expectations of CFOs? Yeah. So in this work, we had access to survey the trend for since the year 2001. And 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 in 10 chance the realized return is going to be above this number.

1:17:43And what is the number for which one in 10 times it's going to be below? So 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. So 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 kind of counterintuitive. Any idea what is the confidence interval of the S &P 500? So if I asked you, take your prediction, say 8 % next year, plus minus what will make 80%.

1:18:33I don't know. Off the top of my head, don't know. Oh, so you're under confidence. It's plus minus 20%. This is kind of based on historical data. This kind of generates about 80 % confidence interval. In the data, we actually see that it's plus minus 7%. So it's just too narrow. So instead of plus minus 20%, I would probably say less if I had to, but plus minus 20 % seems kind of really wild. Yeah, but stock market returns are pretty, in two out of 10 years, you get returns that are either above 20 % or below negative 20%. And this kind of goes for a very long time. So you could look at any period in these 22 years of data that we have.

1:19:19And on average, it's 35 % of the time they're right instead of 80%. Wow. How does CFO miscalibration respond to market uncertainty or rising market uncertainty? So when markets are more uncertain, think about fix, high fix, for example, you would anticipate that the confidence interval is going to be wider, right? I mean, if I asked you in March 2020, what do you think about next year? You know, the world could be either the economy is going to be driven to the ground, or maybe there is a rebound, who knows? But what we see is that actually the response of CFOs is kind of asymmetric. They think a lot about the downside and less about the upside.

1:20:03So during times of very high VIX, we get very negative lower bound. Things could be really bad by the end of next year, but we see less of an upside. And it seems, I think, a way of or representative of how people think. They, 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. Do CFOs become better calibrated as they produce more forecasts? So in this study, we have the privilege of serving the same people again and again and again. And some of them go for 20 and sometimes even 30 quarterly forecasts.

1:20:49So we have the same forecast from the same people. And what we see is that miscalibration, the size of this confidence interval, is more or less constant per person. So if you tend to give us relatively narrow forecasts, 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. And if you started with plus minus 15%, you're going to kind of just continue this trend. Now, interestingly, we also see that people who are kind of staying with us for a longer time tend to give us wider confidence intervals.

1:21:35Maybe it's because the confidence interval itself tells you something about just personal trade, tells you something about who you are. or so we see this in data. 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? So CFO miscalibration seems like an inherent characteristic of one's personality. So it's really difficult to work against. Now, ways to overcome it is really to use tools or to use like decision support tools to use data. If before asking you the question, I would tell you the question about the S &P.

1:22:14We tell you, well, here's the historical distribution of what happened in the last 50 years. What do you think now? Well, obviously, I kind of gave 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. So three out of five investment in hedge funds end up in losses. Is this really interesting for you? So maybe you help decision maker, whether this is an investor or executive or just household, you help them with data. So I think this is kind of what could help.

1:22:52That's nice. Yeah. So basically base rates, right? Yeah, absolutely. Amazing. Our final question for you, Zahi. How do you define success in your life? Thank you. Thank you for this question. So this question actually was the topic of dinner conversations at my household for a few nights. So I have four kids ranging between ages 10 and 21. And we had a conversation about success and goals. And my kids reminded me that I oftentimes told them, push the envelope. So you should work as hard as you can until you fail. And then you know that you succeeded. So if I try to kind of generalize this, success really depends on the goals you set to yourself.

1:23:37And in an absurd way, you know you kind of worked to the max and probably succeeded once you start seeing failures. Until then, things are probably too easy for you. So this is what I try to preach and try to live by, sometimes more successful than other cases. but yeah so success is sometimes could be failure that's a really really cool answer to the question is it the coolest ones that you received from i'm just kidding no we've had however many hundred or whatever but it's a unique answer i can say that all right thank you so much ben's gonna give you a high cool rating for having four children yeah i've got four kids too awesome great answer to the question this has been a fantastic conversation zahi we really appreciate you coming on thank you so much it's been a pleasure

1:24:29Thank you.