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The best performing stock market mutual funds generally trade less frequently than their peers who trade more regularly, even when looking at those funds with high active share.
“Our favourite holding period is forever.”
– Warren Buffett
“Buy good companies, don’t overpay and do nothing.”
– Terry Smith
It’s easy to conjure up the stereotypical image of the stock-market operator, sat looking at his six screens all day and placing trades as the news flows in. But in reality, those investors who trade frequently seldom make the best returns – and in actual fact, at the extreme end of the spectrum, the vast majority of trading accounts lose money, with only a fraction going on to be successful over the long term.
The trouble is that as active investors many of us tend to automatically assume that we must take constant action in response to all the myriad events taking place in the world in order to adjust our portfolios. Yet time and again, the evidence shows that those who trade the least often tend to perform the best over the long term.
We must be careful not to conflate active management and high portfolio turnover (frequent trading). An active manager can be active in the sense that they have a high active share (the portion of a portfolio that differs from the constitution of the benchmark index) but at the same time relatively inactive in the sense that they don’t trade very regularly.
In fact, many of the most successful active investors place a lot of emphasis on inaction: the quotes featured at the beginning of this article are testament to that. Investors like Warren Buffett and celebrated British fund manager Terry Smith pride themselves on ‘owning businesses’ rather than ‘renting stocks’, which means they have lower portfolio turnover and hold onto their positions for many years – and sometimes many decades – at a time.
The evidence shows that funds with a low portfolio turnover and a high active share tend to outperform their high-turnover counterparts on average.
In a paper published in the Journal of Financial Economics in 2016, Cremers and Pareek found that among high active share funds, only patient funds with long holding durations (top quintile of active share and bottom quintile of portfolio turnover) were able to outperform as a group in the period following portfolio construction. These funds outperformed their benchmark by more than 2% per year on average, whereas frequently trading mutual funds systematically underperform their benchmarks, with the top quintile of short duration funds showing 1.4% underperformance per annum on average.
Cremers and Pareek conclude that their results “underscore the importance of distinguishing between truly active and closet index funds, and, among truly active funds, between managers pursuing short-term mispricing (generally unsuccessfully in our sample) and managers who patiently (and in our sample on average successfully) follow a buy-and-hold strategy with a distinct portfolio.”
What could be the reasons behind the tendency of active managers with a low portfolio turnover to outperform?
Less distracted by noise: Managers that trade less frequently are less likely to chase stock performance and follow the investing ‘herd’ just because something is popular at the time. By the same token, they are less likely to become fearful and sell due to some negative news flow that impacts performance in the short term.
More time for thesis to bear fruit: Fund managers who hold onto a stock for longer have more time for their original investment thesis to play out. Whilst it is practically impossible to gain an informational edge in the very short term, it is possible to do so over the long term if you do your research properly and pick the right stocks. Holding onto positions for longer means there is more time for an informational edge to compound and for compound interest to work its magic.
Higher levels of conviction: Managers who hold on to stocks for longer are more likely to have high conviction in those positions, which suggests a greater level of understanding and research.
If the evidence points to a low portfolio turnover being a major factor in driving investment performance, then why do so many active fund managers trade so frequently in practice?
Performance chasing: Reporting and remuneration for most funds is carried out on a monthly, quarterly and annual basis, which means that it is often in the manager’s interest to utilise “window dressing”. This is where a manager sells stocks with large losses and buys stocks that are flying high, in the hope of boosting the fund’s short-term performance.
To justify ‘active’ fees: Active managers often feel the need to justify their fees by being… well… active. This can lead them to trade and make adjustments to their portfolio in reaction to a particular circumstance or event. However, being reactive rather than proactive is seldom a desirable trait in a fund manager.
Regulations and mandates: Many mainstream funds are governed by rules set down by their regulators which set certain criteria for portfolio composition, including a limit on the level of portfolio concentration and a minimum number of portfolio holdings etc. This can prompt a fund manager to make portfolio adjustments when they otherwise might not have in the absence of such constraints.
Much of the bad press that active managers have attracted of late stems from the fact that many so-called active managers have a low active share and a high portfolio turnover, which naturally leads to a regression towards the mean. This has led to the criticism that few active managers can justify their fees – with which we wholeheartedly agree. The managers that do justify their fees tend to have a high active share and a low portfolio turnover – which is what investors who believe in active investing should look out for.
Disclaimer: This blog is intended for informational purposes only. This blog is not intended to invite, induce or encourage any persons to engage in any investment activities and is not a solicitation or an offer to buy or sell any stock, investment product or other financial instruments. If in doubt, please seek financial advice from an independent financial adviser. Sarnia Asset Management is licensed by the Guernsey Financial Services Commission (GFSC). Past performance is not an indication of future returns. Investments carry risk, including the risk that you will not recover the sum that you invested.
By James Faulkner
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