Mutual fund popularity was growing so fast in the 1960s that the government stepped in with the Investment Company Amendments Act of 1967. The concern around mutual funds was that there was no proof showing that they were actually performing well enough to justify the fees they charge. The mutual fund industry hired ADL to back them up. Fischer Black arranged a meeting with two other leading researchers on CAPM and efficient markets, each with a unique outlook on the problem. Their findings were basically that, although mutual funds are a better value than brokerage firms, they do not outperform the market. They made a deal in which ADL still argued their case on the basis that they are the best value and are competitive therefore regulated by the market. In return, ADL was allowed to include their findings in the case committee files. Afterward, Fischer got married and began publishing his own financial papers.
A for Jack.
ReplyDeleteWhat's going on here is that in the 1960's, mutual funds were getting away with the same thing that individual investors continue to get away with while bragging at cocktail parties: others are unable to evaluate how good their performance actually is, because they don't know how much risk was involved.
This is a huge problem with the recent financial crisis; and it still isn't getting enough attention. If you go back and browse through the investment press in 2005-6, it's all about the high returns being offered by hedge funds, and how you have to compete with that or lose out. Only the curmudgeons mentioned that to get high returns there had to be high risk. Now we know they were right. But, people don't like to be second-guessed, so we're still not talking about this. The aphorism for this is "ignoring the moose in the room".
Also, even back in the 1960's, the SEC is interested in regulating first, and in figuring out how to judge what needs to be regulated is secondary. This came up with the Madoff case this decade: when Markopolous filed accusations that Madoff's profits could not be obtained legally, and used financial arguments, the SEC (which regulates finance) didn't have enough financial professionals to understand the arguments.
Interestingly, Black finds out that Jensen is doing work on this. Jensen is still on everyone's short list, mostly for his later work ... which is the primary reason that agency costs show up in finance texts.
Black meets with Jensen and Sharpe. Sharpe did win a Nobel prize for his contributions to the CAPM. In this section, his Sharpe Ratio is mentioned. Within this decade, the arguments that high returns were being achieved with high risk was supported with evidence from Sharpe Ratios.
Black starts putting all this together into papers that synthesize what he is picking up from all these big name guys.