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Who Needs Investment Funds?

Sam Vaknin, Ph.D. - 11/12/2008

The credit and banking crisis of 2007-9 has cast in doubt the three pillars of modern common investment schemes. Mutual funds (known in the UK as "unit trusts"), hedge funds, and closed-end funds all rely on three assumptions:

Assumption number one

That risk inherent in assets such as stocks can be "diversified away". If one divides one's capital and invests it in a variety of financial instruments, sectors, and markets, the overall risk of one's portfolio of investments is lower than the risk of any single asset in said portfolio.

Yet, in the last decade, markets all over the world have moved in tandem. These highly-correlated ups and downs gave the lie to the belief that they were in the process of "decoupling" and could, therefore, be expected to fluctuate independently of each other. What the crisis has revealed is that contagion transmission vectors and mechanisms have actually become more potent as barriers to flows of money and information have been lowered.

Assumption number two

That investment "experts" can and do have an advantage in picking "winner" stocks over laymen, let alone over random choices. Market timing coupled with access to information and analysis were supposed to guarantee the superior performance of professionals. Yet, they didn't.

Few investment funds beat the relevant stock indices on a regular, consistent basis. The yields on "random walk" and stochastic (random) investment portfolios often surpass managed funds. Index or tracking funds (funds who automatically invest in the stocks that compose a stock market index) are at the top of the table, leaving "stars", "seers", "sages", and "gurus" in the dust.

This manifest market efficiency is often attributed to the ubiquity of capital pricing models. But, the fact that everybody uses the same software does not necessarily mean that everyone would make the same stock picks. Moreover, the CAPM and similar models are now being challenged by the discovery and incorporation of information asymmetries into the math. Nowadays, not all fund managers are using the same mathematical models.

A better explanation for the inability of investment experts to beat the overall performance of the market would perhaps be information overload. Recent studies have shown that performance tends to deteriorate in the presence of too much information.

Additionally, the failure of gatekeepers - from rating agencies to regulators - to force firms to provide reliable data on their activities and assets led to the ascendance of insider information as the only credible substitute. But, insider or privileged information proved to be as misleading as publicly disclosed data. Finally, the market acted more on noise than on signal. As we all know, noise it perfectly randomized. Expertise and professionalism mean nothing in a totally random market.

Assumption number three

That risk can be either diversified away or parceled out and sold. This proved to be untenable, mainly because the very nature of risk is still ill-understood: the samples used in various mathematical models were biased as they relied on data pertaining only to the recent bull market, the longest in history.

Thus, in the process of securitization, "risk" was dissected, bundled and sold to third parties who were equally at a loss as to how best to evaluate it. Bewildered, participants and markets lost their much-vaunted ability to "discover" the correct prices of assets. Investors and banks got spooked by this apparent and unprecedented failure and stopped investing and lending. Illiquidity and panic ensued.

If investment funds cannot beat the market and cannot effectively get rid of portfolio risk, what do we need them for?

The short answer is: because it is far more convenient to get involved in the market through a fund than directly. Another reason: index and tracking funds are excellent ways to invest in a bull market.