Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently by SSRN
University of Notre Dame
September 19, 2014
This paper documents that among high Active Share portfolios – whose holdings differ substantially from the holdings of their benchmark – only those with patient investment strategies (i.e., with long stock holding durations of at least 2 years) outperform their benchmarks on average. Funds trading frequently generally underperform, regardless of Active Share. Among funds that infrequently trade, it is crucial to separate closet index funds – whose holdings largely overlap with the benchmark – from truly active funds. The average outperformance of the most patient and distinct portfolios equals 2.30% per year – net of costs – for retail mutual funds. Stocks held by patient and active institutions in general outperform by 2.22% per year and by hedge funds in particular by 3.64% per year, both gross of costs.
Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently – Introduction
Which, if any, actively managed portfolios can outperform passive benchmarks? The previous literature has documented that, on average, the long?term net performance of actively managed mutual funds is similar to the performance of their benchmark (with actively managed funds generally underperforming their benchmarks but without strong statistical significance on average). However, some papers argue that some smaller subset of actively managed mutual funds – that is identifiable ex ante – is able to consistently outperform, on average, over fairly long periods of time (see, e.g., Cohen, Coval and Pastor, 2005; Kacperczyk, Sialm, and Zheng, 2005; Mamaysky, Spiegel and Zhang, 2008; Kacperczyk and Seru, 2007; and Cremers and Petajisto, 2009). A necessary condition for long?term outperformance is that the actively managed portfolio is substantially different than the benchmark, which is considered in Kacperczyk, Sialm, and Zheng (2005) and Cremers and Petajisto (2009). Both find that mutual funds whose holdings are more different from their benchmarks, on average and in the longterm, outperform their benchmarks net of fees. Kacperczyk, Sialm, and Zheng (2005) consider only industry bets using the Industry Concentration Index, and Cremers and Petajisto (2009) consider all stock positions using Active Share, i.e., the proportion of fund holdings that is different from the benchmark.
Funds with high Active Share have little overlap with the benchmark holdings and thus are truly actively managed. Mutual funds with low Active Shares have similar holdings as their benchmark. Cremers and Petajisto (2009) found that such ‘closet index funds’ have tended to significantly underperform their benchmarks (after fees) in the future by about 1% per year. At the same time, they also found that funds with above 90% Active Share outperformed their benchmarks by about 1% a year, after fees were taken out. Cremers, Ferreira, Matos and Starks (2014) analyze a large international sample of mutual funds domiciled in 32 different countries, and likewise find that high Active Share funds on average outperform their benchmarks in the future while low Active Share funds underperform.
In this paper, we examine the source of this apparent investment skill by the most active managers, focusing on how fund outperformance is related to fund holding durations or how frequently the fund manager trades. Ex ante, it is not clear whether funds would generally be more successful through holding stocks for long periods or through frequently changing the portfolio. On the one hand, if markets are fairly information?efficient, then any information that a fund manager is trading on will be incorporated in the market quickly. As a result, managers may need to frequently trade in order to benefit from their temporary superior information.
On the other hand, fund managers may be able to spot market mispricing that is only reversed over longer periods, requiring strong manager conviction and investor patience. In this case, managers would only outperform by holding stocks over longer periods. This requires a strong conviction on the part of the manager, as stock prices may initially move adversely before reversing any mispricing. Similarly, it requires that investors are fairly patient in giving the manager time to see the strategy through, rather than evaluate the performance are relatively brief periods of time. An investment approach with long holding durations may benefit from opportunities to buy relatively illiquid or deep?value stocks on the cheap (see Amihud, Mendelson and Pedersen, 2005), at the detriment of potentially allowing overconfident fund managers to persist in wrong convictions.
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