Asset Allocation Funds, Private Equity IPOs, and The Efficient Market Hypothesis (EP.66)

Episode Summary

Executive Summary: Episode 66 centers on how theory, data, and behavior interact in investing. The hosts discuss Morningstar’s Mind the Gap findings on investor underperformance, IPO/private-market valuation distortions and skewness in VC, and why financial theory should be tested—not treated as dogma. They close with a retirement-planning reflection using marathon pacing, and a sharp critique of deferred sales charges and their behavior-driven costs.

Main Topics: Investor behavior gap vs. mutual fund returns (Priority: 5/5): The hosts review Morningstar’s Mind the Gap 2019, focusing on how investor timing decisions cause returns to lag the funds they own. They highlight that behavior, volatility, and fees can materially reduce realized performance. Private equity, venture capital, and IPO valuation excesses (Priority: 5/5): They discuss recent IPO turbulence (especially WeWork) and how private-market pricing can diverge dramatically from public-market reality due to illiquidity, information asymmetry, and aggressive valuations. Skewness and return concentration in public markets and VC (Priority: 4/5): The conversation emphasizes that a tiny fraction of stocks drive market returns and that venture capital outcomes are even more skewed, which makes diversification and selection especially difficult in private markets. Theory vs. empirical evidence in finance (Priority: 5/5): A major theme is how financial theories and empirical results should coexist: theory guides testing, empirical data refines theory, and neither should be reduced to anecdotes or post-hoc storytelling. Market efficiency and misunderstood debates (Priority: 4/5): The hosts argue that crashes or bad outcomes do not disprove market efficiency; efficiency is about information being reflected in prices, not about prices being correct or stable. Retirement planning framed as goal-setting (Priority: 3/5): Using marathon finish-time clustering as an analogy, they discuss setting concrete retirement targets, building plans around spending and savings constraints, and recognizing that markets can still derail plans despite good process. Critique of deferred sales charges (Priority: 4/5): They condemn DSC mutual funds as a behavior- and commission-driven product structure that is fading in practice but still survives in policy debates, arguing it misaligns advisor incentives and investor outcomes.

Key Arguments: Investors often underperform the funds they own because they buy and sell at the wrong times, and that gap widens in more volatile asset classes. Lower volatility, diversified, boring funds can improve outcomes not just through fees but through better investor behavior. The cause of the behavior gap is not fully known; it may reflect poor timing, forced withdrawals, or selection bias, but the pattern is robust. Private-market pricing is highly vulnerable to information asymmetry and overvaluation, as shown by huge post-IPO write-downs relative to last private marks. IPO stocks have historically underperformed the market because they tend to resemble small-cap growth, low-profitability, aggressive-investment firms. A tiny fraction of stocks generate outsized market returns, which means diversification through index funds is crucial in public markets and even more important in private markets where diversification is harder. Financial theory should not be judged by whether it tells a simple story about winners like Warren Buffett; it should be judged by whether it generates testable implications. Market efficiency means prices reflect available information, not that crashes cannot happen or that markets never misprice assets. Setting explicit retirement goals can be useful, but outcomes remain constrained by savings capacity, spending needs, and market risk. Deferred sales charges persist mainly because of legacy industry structures, but they are increasingly hard to justify given modern low-cost, fee-for-service alternatives.

Data Points: Average investor underperformance vs. fund performance: 45 basis points (0.45%) annualized - Morningstar Mind the Gap 2019, averaged across five 10-year periods ending December 2018 Asset allocation fund gap: +22 basis points annualized - Asset allocation funds were the only broad category with a positive investor-fund performance gap on average Alternative funds gap: 144 basis points - Investors in alternative products had the widest negative gap due to higher volatility and timing effects Alternative fund performance: -61 basis points annualized - Funds in the alternatives category underperformed on a fund-return basis before investor timing effects were added Global stock return concentration: 1.3% of global stocks - A cited study found this small share of stocks drove all excess returns over T-bills from 1990 to 2018 VC financing return distribution: 21,640 financings - Study covering venture capital deals from 2004 to 2013 VC zero-to-1x outcomes: 65% - Largest share of VC deals produced between 0 and 1x return VC 1x-to-5x outcomes: 25% - Middle tier of venture outcomes in the cited study VC 5x-to-10x outcomes: 5.9% - High-return but relatively rare venture outcomes VC 10x-to-20x outcomes: 2.5% - Very strong venture outcomes VC 20x-to-50x outcomes: 1.1% - Rare outsized venture outcomes VC 50x+ outcomes: 0.4% - Extremely rare venture winners IPO portfolio underperformance: 2.2% annualized - Dimensional’s hypothetical IPO portfolio trailed the market from 1992 to 2018 IPO study period: 1992 to 2018 - Dimensional study of U.S. IPO issues Marathon study sample: 2.9 million runners - Study of marathon completion times across global events ending in 2017 Marathon events covered: 196 marathons / 784 events - Scope of the marathon timing study Marathon geographies covered: 238 nationalities, 39 countries, 7 continents - Breadth of runner dataset used in the marathon study Fastest age group in marathons: 40 to 49 - This age cohort had the best overall times in the cited study DSC commission example: $5,000 to $6,000 on a $100,000 purchase - Example given from the 1990s to illustrate front-end/back-end load economics Hypothetical retirement spending rule: $30,000 savings per $1,000 annual spending - Michael Kitsis rule of thumb used to frame retirement planning

Pivotal Quotes: "Efficient markets is a simple sounding principle with a lot of hard thinking needed to make it useful, that organized a vast empirical project in financial economics." — John Cochran and Tobias Moskowitz (quoted in preface to The Fama Portfolio): Explaining how Fama’s ideas provided a framework for empirical finance, similar to evolution in biology "Efficiency in finance means information and only information. An informationally efficient market can suffer economically inefficient runs and crashes, so long as those crashes are not predictable." — John Cochran and Tobias Moskowitz (quoted in preface to The Fama Portfolio): Clarifying that market efficiency is about information incorporation, not preventing crashes "Look at the facts, collect the data, test the theory. Every time we look, the world surprises us totally, and it will again." — Gene Fama (quoted): Summarizing the episode’s core approach to evidence-based financial thinking

Implications: Listeners should focus less on narratives and more on evidence: minimize fees, manage behavior, diversify broadly, and test assumptions. For the industry, the episode reinforces skepticism toward hype in IPOs, VC, and DSC products, and favors theory-guided, data-tested decision-making.