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Meet the New Boss, Same (School) as the Old Boss

Don Phillips: The influence of behavioral finance is seen across the industry.

Don Phillips, 10/01/2009

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The University of Chicago's Milton Friedman forged the economic philosophy that defined the Ronald Reagan, laissez-faire economics that dominated the past quarter-century. Now, the U of C's Richard Thaler and the behavioral- finance movement seem poised to define the post-bubble, Barack Obama, "new normal" era. Behavioral finance has swept through the industry at astonishing speed, moving from amusing anecdotes about how we all believe ourselves to be above-average drivers to policy changes that alter the way Americans save for retirement and raising fundamental questions about the governance of financial services.

Financial planners were early supporters of behavioral finance. Planners knew that their clients were not the supremely rational decision-makers envisioned in classic economic theory. They were real people subject to emotions and biases. Planners grasped immediately that this burgeoning field could help them understand client tendencies and, in time, nudge clients toward better decisions. Financial-services companies and Washington policymakers were similarly quick to jump on the bandwagon as a means of improving our nation's retirement-savings programs. Opt- out 401(k) policies, default investment choices, and automatic step-up plans have already revolutionized retirement planning.

As behavioral finance enters our collective financial thinking, its influence is apt to be seen in the regulatory framework that governs the investment industry as well. We may already be seeing this happening. Fund-fee regulations have long been guided by the 1982 Gartenberg decision, which asserts that high fees may be a breach of fiduciary duty by a fund board if the fee is "so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining." The reliance on arm's-length bargaining is essentially a free-market argument: It assumes that markets are efficient and that a large group of informed participants, including fund company boards, are capable of establishing standards that can be used to judge the actions of others.

Defense attorneys have successfully interpreted this ruling to argue that if a fund's fees are similar to others', then the fund's board has met its fiduciary obligation. A challenge to Gartenberg arose in 2008's Easterbrook decision in the case of Jones v. Harris Associates. The decision moved further in a free-market direction, saying that fees need not necessarily be similar to those of other negotiated fees, so long as the fund provides full disclosure and uses no tricks in presenting the fee information. This struck many as a windfall, especially at a time of burgeoning distrust of financial services. A legal counselor in the fund industry even conceded that the Easterbrook decision effectively eliminated the ability of investors to sue their funds over fees. While the differences between Gartenberg and Easterbrook may lead to different consequences for investors, the two decisions both rest on traditional economic thinking. Easterbrook just takes it one step further and says that so long as the information needed to make a rational, informed choice is available, market forces will process that data and lead to efficient and fair outcomes for investors.

But the Easterbrook decision also brought a thunderous new voice: Judge Richard Posner, in a powerful dissent that ultimately persuaded the U.S. Supreme Court to take up the case. Posner essentially makes a behavioral-finance argument, saying that the Easterbrook ruling was based "on an economic analysis that is ripe for re-examination on the basis of growing indications that executive compensation in large publicly traded firms is excessive because of feeble incentives of boards of directors to police compensation." He notes that "competition in product and capital markets can't be counted on to solve the problem because the same structure of incentives operates on all large corporations and similar entities, including mutual funds."

In essence, he argues that markets are not perfectly efficient--that large numbers of actors, such as fund boards, may be subject to biases. Before the rise of behavioral finance, it would have been inconceivable for a Chicago-school judge like Posner to regard a large, well-populated industry with open admissions as being inefficient. Posner believes in free markets, but he suggests that fees negotiated between institutional buyers and an asset-management company may better represent an arm's-length transaction than do fees set by fund boards because of inherent biases.

Today, many observers question the assumptions that have underpinned our economic system for the past few decades. Behavioral economics' tweaking of traditional economic theory seems very much in keeping with the "new normal." It seems clear that behavioral finance's time has come.

Don Phillips is Morningstar's managing director, corporate strategy, research, and communications.

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