Episode 268: Itzhak Ben-David: ETFs, Investor Behavior, and Hedge Fund Fees

Episode Summary

Executive Summary: Professor Itzak Ben-David discussed how financial products and investor behavior interact in surprising ways. The conversation covered ETF proliferation, specialized ETF speculation and underperformance, ETF-induced volatility in underlying stocks, mutual fund flow chasing and Morningstar’s 2002 rating change, hedge fund fee frictions that far exceed “2 and 20” in practice, tax-refund mental accounting, and CFO miscalibration. Across topics, the theme was that investor attention, institutional design, and behavioral biases often drive outcomes more than pure fundamentals.

Main Topics: ETF market evolution and product proliferation: Ben-David explained how ETFs evolved from broad index products into increasingly niche, thematic offerings designed to capture investor attention and differentiate in a crowded market. Specialized/thematic ETF performance and investor sentiment: He argued that specialized ETFs often launch into hot themes after the best performance has already occurred, attract flows after gains, and then underperform over time. ETF market impact on underlying securities: The discussion covered how ETF trading transmits demand shocks to underlying stocks, potentially increasing volatility and creating noise as well as information. Mutual fund investor behavior and Morningstar ratings: Ben-David described how investors chase past performance and Morningstar stars, and how Morningstar’s 2002 style-based rating change altered flow patterns and affected style returns. Hedge fund fees and incentive structure: He showed that hedge fund investors often pay much more than the nominal ‘2 and 20’ due to fee asymmetries, performance chasing, and fund closures. Mental accounting and tax refunds: The conversation examined why people treat tax refunds differently from tax payments, showing that households mentally separate identical cash flows based on source and framing. CFO miscalibration and overconfidence: Ben-David explained how CFOs are systematically overconfident in forecasting and remain poorly calibrated even after repeated forecasting experience.

Key Arguments: ETF growth is a story of both democratization and attention competition: broad index ETFs expanded access, but niche thematic ETFs are often designed to capture investor sentiment rather than improve long-term portfolio outcomes. Specialized ETFs tend to launch after the underlying theme has already outperformed, so investors are often buying late into a trend; average subsequent five-year performance is poor. Flows into thematic ETFs are highly performance-sensitive, which suggests speculation rather than hedging behavior. ETF trading can move underlying securities because arbitrage links ETF prices and constituent stocks; this can raise volatility and introduce noise, especially in less liquid names. Morningstar ratings matter because investors chase stars, but the 2002 shift to style-relative ranking reallocated flows across styles, reducing style concentration and changing market dynamics. Mutual fund investors and even many professionals primarily chase raw returns and Morningstar stars, not alpha or risk-adjusted performance. Hedge fund fees are much larger in practice than the headline contract suggests because gains are taxed by incentive fees while losses are not symmetrically rebated; the effective profit share to managers is far higher than 20%. Tax refunds are treated as windfalls and spent differently from tax payments because of mental accounting, even though economically they are the same cash flow with a different sign. CFOs are miscalibrated: their forecast intervals are too narrow, and this bias persists over time, implying that decision support and base rates are more useful than intuition alone.

Data Points: ETF launch cost: about $100,000 - Estimated cost to launch a new ETF in the discussion of product competition and niche creation ETF market structure: thousands of ETFs - Professor Ben-David described the current global and U.S. ETF landscape ETF history: 1993 - Year the first major ETF (“Spider”) was launched Specialized ETF market share of assets: about one-sixth - Specialized ETFs’ share of U.S. ETF assets Specialized ETF share of fees: about one-third - Specialized ETFs generate a disproportionate share of industry fees Specialized ETF long-run performance: negative 30% over five years - Average post-launch performance of specialized/thematic ETFs Specialized ETF life cycle: 12 to 24 months - Typical period in which niches experience strong prior performance before ETF launch Morningstar fund universe: top 10% = five stars; next 22% = four stars - Explanation of the pre-2002 Morningstar ranking system Morningstar minimum history: 3 years - Funds had to exist at least three years to receive a rating CFO calibration accuracy: about 35% - Share of time CFOs’ forecast intervals contained realized S&P 500 returns instead of the intended 80% Intended forecast interval coverage: 80% - The target confidence interval in the CFO survey Observed CFO interval width: plus/minus 7% - Typical CFO forecast interval for S&P 500 returns in the study Benchmark interval example: plus/minus 20% - Illustrative historically reasonable interval for an 80% confidence band around S&P 500 returns Hedge fund nominal fee structure: 2% management fee and 20% performance fee - Standard “2 and 20” contract structure described in the hedge fund section Hedge fund realized fee burden: about 50% of profits - Average share of profits paid to incentive fees over the sample period Combined hedge fund fee burden: close to 65% of profits - Total profit share going to hedge fund managers after combining management and incentive fees Unjustified hedge fund incentive fees: about 30% - Portion of incentive fees not justified by eventual long-run profits because gains were later offset by losses Liquidity restriction example: 3 to 6 months or longer - Typical redemption lockups mentioned for hedge funds versus ETFs/mutual funds

Pivotal Quotes: "Thematic ETFs appear to appeal to this type of investors who are being driven by sentiment. And on average, they are going to lose 30% over five years." — Itzak Ben David: Advice to retail investors tempted by niche ETF themes "We see actually no alpha chasing whatsoever. It's all about Morningstar and unadjusted returns." — Itzak Ben David: Summary of mutual fund investor flow behavior "Instead of 20% in the contract, 50% went to investors." — Itzak Ben David: Core result from the hedge fund fee study showing effective fee burden

Implications: For investors, the message is to be skeptical of thematic hype, star ratings, and headline fee structures. For markets, product design and ranking rules can materially change flows, volatility, and pricing. Behavioral frictions remain central to asset prices and household decisions.