Exclusive Interview with Stanford Professor Charles Lee: Why Fees May be Less Important to 401k Plan Sponsors

Stanford Professor Charles Lee finds evidence against market efficiency “liberating” and views behavioral theories “primarily as opportunities.”A decade ago he suggested a “naïve view of market efficiency, in which price is assumed to equal fundamental value, is an inadequate conceptual starting point for future market-related research.” He has said the Efficient Market Hypothesis (“EMH”) “is an over simplification that fails to capture the richness of market pricing dynamics and the process of price discovery.” He points out its current use operates “with no reference to the original caveat.” He feels “that moving from the mechanics of arbitrage to the EMH involves an enormous leap of faith. It is akin to believing that the ocean is flat, simply because we have observed the forces of gravity at work on a glass of water.”

How does this impact the typical 401k plan sponsor? Reading between the lines, it appears Professor Lee’s research exposes two myths commonly perpetrated by some in the financial services industry and seemingly taken as “accepted” or “standard” investment theory by regulators. The DOL recently proposed new rules for 401k fee disclosure. Columnist Chuck Jaffe simplified the proposal to this simple maxim: “Low costs are good.” In what might surprise many, Professor Lee maintains “we should therefore expect the after-fee performance of active managers to approximately equal their benchmark.” In one statement, he not only refutes the naïve oversimplification of fees, but also erodes the all-too-common lore regarding the “predominance” of index investing over active management. It’s therefore critical 401k plan sponsors – indeed, any fiduciary for that matter – fully vet all the relevant research as part of their standard due diligence process.

Recently, Fiduciary News spoke with Professor Charles Lee. Here’s what he had to tell our reader:

FN: It seems like academic studies “proving” index investing trumps active investing get all the press. We know from real life (the 2010 “lost decade” article in Fiduciary News, the 2005 “Emperor Exposed” research study in the Journal for Financial Planning) that sometimes active wins and sometimes passive wins. There is no clear “only” or “best” way to invest in terms of active or passive. So, why then is there this consensus that “passive beats active” is the only way to think?
Lee: I don’t understand that either.  Index funds are not a new invention. It is silly to argue that, almost 40 years after their invention, index funds remain, collectively, a “colossal bargain.” If they are, then the size of the active management business (over one trillion dollars just in hedge funds) must be the biggest behavioral anomaly of all.

I am glad to see many well-run index funds are now available to retail investors at low costs. But there will always be active managers, because that is what the indexers are free riding off of. The social value of markets derives from this public good called “the approximately right price,” which the active managers help produce and the passive managers (as well as all decentralized decision makers in a free economy) exploit. The question is whether this public good is being priced correctly (i.e. whether active managers as a whole are charging the right economic rent for their talents/efforts).

I think, on average, the typical active manager will beat the market before fees and look, well… AVERAGE, after fees. That is what competitive equilibrium looks like. That seems to be what the most recent academic evidence suggests.

As one of your earlier columns noted, people probably under-weight the effect of fees and over-weight past performance (alternatively, we might say they have a preference for “positive skewness,” or the “lottery-like” attributes of certain asset classes, such as actively-managed funds).  That, plus the over-confidence bias, might suggest that not enough people are indexing.  However, the “passive beats active” mantra is definitely getting old.

Your readers might be interested in the article I wrote on market efficiency and behavioral finance (“Market efficiency and accounting research: a discussion of ‘capital market research in accounting’ by S.P. Kothari” Journal of Accounting and Economics (“JAE”) 31 (2001) 233–253). In this article, I offer a detailed treatise on the problems with a naïve faith in market efficiency, as well as the importance of behavioral finance. This is a carefully written piece that has been received well and withstood the test of time.

FN: It’s been said Modern Portfolio Theory (“MPT”) begat the Rational Investor which in turn begat the Efficient Markets Hypothesis (“EMH”) which ultimately begat Index Investing. In what ways have Behavioral Economics (“BE”) eroded some of the fundamental axioms of MPT and EMH?
Lee: I am not sure I agree with the causal chain. Modern economics, like all social sciences, begin with some assumptions about the Nature of Man. Thus the Savage axioms of rationality (assumptions we make about the “Rational Man,” or “Rat” for short) is foundational. To these axioms, we add somewhat cavalier assumptions about costless arbitrage, and we get the EMH and the Capital Asset Pricing Model (“CAPM”). MPT is a latter-day derivation of the CAPM that has been adapted for use by many advocates of active management.

How is all this related to behavioral economics? BE strikes at the root of this causal chain.  It states that the “Rat” is not always so predictable (or at least in casual observation, he seems to depart from the predictions of normative theory). If the basic agents are not fully rational, we cannot expect equilibrium results to be quite so stable as theory suggests. BE states that prices are constantly buffeted by waves of investor sentiment apart from fundamental values, and that only the constant vigilance and (constrained) resources of the arbitrageurs keep markets from going further astray.

Sections 2.2 and 2.3 in the JAE article discuss the nature of our faith in the EMH. Fiduciary News readers might find the discussion on “The limits of arbitrage” (Sec 2.4) and “What’s wrong with the traditional model” (Sec 2.5) in the article useful as well.

As an aside, MPT, as practiced by many active managers today, is actually quite a useful bastardized version of a multi-factor CAPM or Arbitrage Pricing Theory (“APT”).  It is bastardized because it does not actually preclude the existence of alpha (whatever is left unexplained by the factors is, if consistently positive, deemed alpha). Moreover, it does not use portfolio returns as risk factors, and does not use time-series betas as factor loadings. Finally, it actually builds in transaction costs and other costs of arbitraging a bet. So, all in all, MPT is not necessarily incompatible with behavioral investing. It can be a useful tool – like a tractor to a farmer – so a good risk model can help an equity portfolio manager zero in on a pure alpha (often behavioral) bet.

Some aspects of MPT are quite useful to investors as well. For example, it can help us separate Alpha from Beta. Beta is cheap and Alpha is scarce. Investors should not pay Alpha prices for Beta products. Just as scotch and soda should not be sold, by weight, like scotch neat. Today, we see increased user sophistication in this area, as people are asking the right types of questions of active managers – what is your expected correlation with the market, how much of your returns is actually a Beta bet, how much active risk are you taking to earn your active returns, etc. In these portfolio management applications, MPT does not require strong rationality assumptions. Risk models such as BARRA simply measure and forecast asset co-movements, and is agnostic as to the source of these co-movements.

FN: What do you see a replacing the old “rational investor” MPT as the preferred academic theory?
Lee: In Sec 3 of the JAE article, I describe a form of “Rational Behavioral Model”. I don’t know whether these models are replacing the old models, but in my view they offer a promising direction.

FN: In seeking comment on the proposed revision to the Advisor Rule, the DOL recently asked the industry to comment on “standard investment theory.” In the paper you’ve referenced, you said “the market knows better than the government.” What is the potential downside for the government to decree a “standard investment theory” in its rules and regulations?
Lee: Hmmm… I think it is useful to explain to most individual investors the various descriptive characteristics of the core asset classes, and the relative importance of strategic asset allocation (vs. market timing and security selection), in developing an investment plan. But I have a hard time going beyond that in sketching the outlines of a “standard investment theory.”

FN: What do you see on the horizon regarding behavioral investing?
Lee: The core of behavioral investing is identifying attributes that investors tend to over- and under-price. The former tend to be more salient but less reliable than the latter. Boring accounting quality indicators, for example, tend to be under appreciated by investors. Sexy growth numbers and what Malkiel calls “Castle in the air” stocks tend to be over-priced. The empirical proxies change, but the basic concepts do not.

FN: Do you feel (a la the Groucho Marx article) index investing exposes a theoretical free rider problem that, taken to the extreme, could (also theoretically) destroy the capital market?
Lee: Absolutely. I make this argument in my article.

FN: Is there anything else you’d like to say?
Lee: People who really respect market efficiency study it; they do not assume it.

FN: Professor, thank you very much for sharing with our readers your thoughts on some of the misconceptions in the use and promotion of indexing and active management as well as your insights in the evolution of investment theory.