Column: Among active managers patience is the principal virtue - James Saft

[July 21, 2016]  By James Saft

(Reuters) - If you are going to use active investment managers you may want to limit yourself to those who are both truly active and, crucially, unusually patient.

A recent study shows that funds which deviate substantially from the indices they track and which have average holding periods of more than two years perform exceptionally well, outperforming, on average, by two percentage points per year.

What’s more, that subset of actively managed portfolios was the only one to so outperform, according to the study, by Martijn Cremers of the University of Notre Dame and Ankur Pareek of Rutgers Business School.

The important distinctions here are two; how high is the “active share” of a portfolio and how long does it tend to hold its investments. Active share is a concept invented by Cremers and colleagues which measures the actual deviation a given portfolio takes from the holdings of its base index. This allows us to sort the “closet indexers” from the real active fund managers. Closet indexing is both quite widespread, due to managers wanting to minimize their own career risk, and a bit of a rip-off, as you pay for active but get something pretty close to an index fund.

The study looked at mutual funds and institutional portfolios and sorted them by both active share and average holding period.

So while frequent trading in the study was linked to underperformance, simply holding investments for longer did not lead to better performance unless it was by the sub-set of portfolios which were also taking big bets against the index.

“Our results suggest that U.S. equity markets provide opportunities for longer-term active managers, perhaps because of the limited arbitrage capital devoted to patient and active investment strategies," Cremers and Pareek write. (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2498743)

Why? Hard to know for certain, but it seems that arbitrage opportunities may be thrown up by the huge numbers of closet indexers who self-servingly hew to their benchmarks while trading relatively often.

“The literature on limited arbitrage has argued that trading on long-term mispricing is more expensive and difficult, especially if the fund manager risks being fired in the short term before ex-post successful long-term bets pay off. In equilibrium, that could allow relatively more long-term mispricing and thus greater profitability for the more limited arbitrage capital that is pursuing patient active strategies.”

In other words, in a rather fundamental way, patient but active investors are making money because other fund managers are afraid to get fired.

PATIENCE IS A VIRTUE, BUT WITH HIGH UPFRONT COSTS

All of this accords well with remarks at a CFA Institute conference this week by noted value investor Leah Joy Zell who said that taking profits from good investments too soon was often a source of regret.

A trader raises his hand to bid on stock prices as he works on the main trading floor of the New York Stock Exchange early in the trading session, December 8, 2008. REUTERS/Mike Segar

This makes sense. It is expensive, for a value investor like Zell, to find and research companies, taking a large upfront investment in time and energy. Simply selling one of these on after 18 months and a 60 or even 90 percent return may not fit well with the investment or business model of a bottom-up value-oriented firm.

Covering more than 20 years, the median holding period among mutual funds ranged as low as 0.9 year in the bubble year of 1999, eventually climbing to 1.7 years. This indicates that recent trends towards higher stock trading and shorter holding periods are probably down to program and algo traders, as opposed to mutual funds. Longer holding periods were “unconditionally” associated with better results, the study found, regardless of active share. Yet the only funds to show statistically significant outperformance combined high active share with long holding periods.

Those funds which did outperform used familiar strategies but stuck with the stock bets these strategies threw up.

“Their outperformance can largely be explained by their focus on stocks that other investors shun or find less attractive: picking safe (low beta), value (high book-to-market) and high quality (profitable, with growing profit margins, less uncertainty, higher payout) stocks and then sticking with those over relatively long periods until their apparent undervaluation has been reversed.”

For investors seeking managers, this data will place new importance on fund selection. To enjoy these benefits investors are going to have to be willing to suffer potentially long periods of outperformance and big deviations from what the rest of the market is doing. Chopping and changing because your manager has done poorly over a year or two is not likely to yield good benefits.

Find someone who has shown skill, makes conviction bets and sticks with them. Then stick with her.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(Editing by James Dalgleish)

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