Oberweis International Opportunities Fund (OBIOX) portfolio manager Ralf Scherschmidt is such a big fan of behavioral economist Dan Ariely that he and his team reread the Duke University professor’s best-selling book at least once a quarter.
Ariely’s book, Predictably Irrational: The Hidden Forces That Shape Our Decisions, serves as the inspiration behind the Chicago area-based Oberweis team’s investment strategy, which has resulted in a 20.88% year-to-date total return on OBIOX. The Oberweis fund is the No. 1-ranked fund in the foreign small/mid growth category, according to Morningstar. No. 2-ranked Oppenheimer International Small Co A has seen a 13.69% year-to-date total return as of Monday.
With that behavioral finance knowledge in hand, the OBIOX team identifies small-cap companies in the developed world that are overlooked by market bias and then takes advantage of earnings surprises. When a company’s fundamentals improve significantly and result in earnings that surprise the market, investors often struggle to immediately accept the change because they are biased by their previous estimates.
‘The Initial Human Reaction Is to Resist a Change in Belief’
“If the market did understand the underlying fundamentals, there wouldn’t be a surprise in the first place,” said the 37-year-old Scherschmidt (left) in an interview on Friday, noting that market players are human beings subject to inherent biases. “It takes the market a long time to incorporate new information into stock prices. People’s original belief about a business gets proven wrong, but the initial human reaction is to resist a change in belief. That’s what we can take advantage of.”
Scherschmidt, who launched OBIOX on Feb. 1, 2007, first learned about the economic theory of behavioral finance as a Harvard MBA student. When working under portfolio manager Joel Dobberpuhl of Jetstream Capital, a Tennessee hedge fund that has since closed, Scherschmidt learned to apply the theory as a stock picker.
To be sure, OBIOX’s stellar performance is due in part to greater market forces. Quantitative Equity Strategies founder Ben Warwick reported in his monthly index report for June that small-cap growth stocks have outperformed all other asset classes year to date, with the Russell 2000 Growth Index posting a 17.4% YTD return. 280% Turnover, 1.6% Expense Ratio
Because the fund’s strategy is based on how long it takes people to change their behavior after seeing they were wrong, the best situations involve a high return in a short time span – but as a result, OBIOX saw a high 280% turnover ratio in 2012, which pushed up the fund’s expense ratio to a relatively high 1.6%.