Pace Insurance is a large, multi-line insurance company that also owns several proprietary mutual funds. The funds are managed individually, but Pace has an investment committee that oversees all of the funds. This committee is responsible for evaluating the performance of the funds relative to appropriate benchmarks and relative to the stated investment objectives of each individual fund. During a recent investment committee meeting, the poor performance of Pace's equity mutual funds was discussed. In particular, the inability of the portfolio managers to outperform their benchmarks was highlighted. The net conclusion of the committee was to review the performance of the manager responsible for each fund and dismiss those managers whose performance had lagged substantially behind the appropriate benchmark.
The fund with the worst relative performance is the Pace Mid-Cap Fund, which invests in stocks with a capitalization between S40 billion and $80 billion. A review of the operations of the fund found the following:
• The turnover of the fund was almost double that of other similar style mutual funds.
• The fund's portfolio manager solicited input from her entire staff prior to making any decision to sell an existing holding.
• The beta of the Pace Mid-Cap Fund's portfolio was 60% higher than the beta of other similar style mutual funds.
• No stock is considered for purchase in the Mid-Cap Fund unless the portfolio manager has 15 years of financial information on that company, plus independent research reports from at least three different analysts.
• The portfolio manager refuses to increase her technology sector weighting because of past losses the fund incurred in the sector.
• The portfolio manager sold all the fund's energy stocks as the price per barrel of oil rose above $80. She expects oil prices to fall back to the $40 to S50 per barrel range.
A committee member made the following two comments:
Comment 1: "One reason for the poor recent performance of the Mid-Cap Mutual Fund is that the portfolio lacks recognizable companies. I believe that good companies make good investments."
Comment 2: "The portfolio manager of the Mid-Cap Mutual Fund refuses to acknowledge her mistakes. She seems to sell stocks that appreciate, but hold stocks that have declined in value."
The supervisor of the Mid-Cap Mutual Fund portfolio manager made the following statements:
Statement 1: "The portfolio manager of the Mid-Cap Mutual Fund has engaged in quarter-end window dressing to make her portfolio look better to investors. The portfolio manager's action is a behavioral trait known as over- reaction."
Statement 2: "Each time the portfolio manager of the Mid-Cap Mutual fund trades a stock, she executes the trade by buying or selling one-third of the position at a time, with the trades spread over three months. The portfolio manager's action is a behavioral trait known as anchoring."
The committee member's Comment 1 could be best described as example of:
- menial accounting.
- representativeness.
- hindsight bias.
Answer(s): B
Explanation:
Assuming that good companies make good investments is representativeness. Think of representativeness as "if-then." (If this, then that.) In this case the committee member applies if-then by assuming that if a company is good (however defined) then it is a good investment. Representativeness can also be exhibited as an overreaction to the historical investment success of a company. The investor uses the past performance as the "if" and good future performance as the "then." The basic idea of mental accounting is that decision makers tend to debit costs associated with transactions to different "mental accounts." A precondition is that these mental accounts are regarded independently of each other. Thus, mental accounting becomes important in the context of relative evaluation. Hindsight bias is the tendency on the part of investors to overestimate what they knew or should have known. (Study Session 3, LOS 9.a)