The clash between a priori and experimental economics was joined in the Supreme Court last month in the case of Jones v. Harris Associates. The narrow question is the standard under which compensation to mutual fund managers should be judged excessive. But how the Court answers this question may have broad implications for future judicial recognition and remediation of market failure in diverse areas of law.
The question comes to the Court by way of a law-and-economics nerd’s equivalent of an Ali-Frazier bout. In the efficient-market corner, United States Seventh Circuit Court of Appeals Chief Judge and University of Chicago professor Frank Easterbrook dismissed concerns that most investors are too unsophisticated to compare prices on the ground that it generally takes just a few sophisticated investors to create sufficient competitive pressure to protect the rest. Against him, fellow Chicago professor and past Chief Judge Richard Posner marshaled empirical evidence that markets have in fact failed to curb excessive pay to fund managers.
While Posner couches his claim of market failure largely in terms of agency problems and moral hazard, a friend of the court brief by scholars Robert Litan, Joseph Mason, and Ian Ayres advances the argument on grounds of behavioral economics and informational asymmetries. The “cognitive anomalies” that they claim “render it nearly impossible for the vast majority of investors to assess the price-adjusted quality of mutual funds” include:
- “Misperceptions of chance” – e.g., the widespread and incorrect impression that “if a roulette wheel has repeatedly hit black, then red is somehow due.”
- “Sample-size neglect” which “means that investors will be far too likely to consider a few years of above-average mutual fund performance evidence of managerial skill when in reality it has been driven by the random fluctuations inherent to the stock market.”
- “Loss aversion” exacerbated by “mental accounting,” which causes investors to “segregate their portfolios based on the principle of limiting their disutility from losses” rather than “considering their financial investments in terms of an aggregate portfolio of investments as traditional financial economics assumes.”
The resulting “propensity to sell winners too early and hold losers too long,” coupled with information costs associated with identifying which funds are winners and losers net of fees, make it “difficult for investors to recognize and reward high-quality, low-cost mutual funds.”
The remainder of the brief goes on to show that high-cost, low-quality mutual funds are not being disciplined by the market, and concludes that the “few sophisticated investors” hypothesis advanced by Judge Easterbrook lacks empirical support. Nevertheless, Chief Justice Roberts and Justice Scalia were reportedly receptive to this theory during oral argument. Where the remaining Justices will come down remains to be seen. But if behavioral-economic arguments can attract a majority of the Court in this case, who can say what neo-classical economic orthodoxy will be the next to fall?