Is Passive Perfect? High Active Share Long-Term Investing Works Better

Is Passive Perfect? High Active Share Long-Term Investing Works Better

April 30, 2015 Research Insights, Value Investing Research, Active and Passive Investing, $iwd
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(Last Updated On: January 18, 2017)

Patient Capital Outperformance

Abstract:

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.

Alpha Highlight:

We love passive investing because it tends to be low-cost and tax-efficient. There are a lot of great papers on this subject, and performance over the past few years has been stellar for passive managers–especially when compared to their over-priced closet-indexing friends. But we also believe–based on the evidence–that long-term active investors who are focused on the right process can do better than passive investing.

This paper, written by Cremers and Pareek, points out that frequent traders generally underperform patient investors, or investors with long duration holdings.

The paper also highlights that not all patient traders are wise and skilled. Among long-horizon fund operators, it is critical to distinguish between closet index funds and truly active funds.

  • Highly Active Managed Funds: the proportion of portfolio weights that does not overlap with benchmark weights is higher than 90%.
  • Closet index funds: the proportion of portfolio weights that does not overlap with benchmark weights is lower than 60%.

Here’s the main finding of the paper:

  • Only Active managers with a Long-Term View are rewarded for deviating from passive benchmarks.

Key Findings:

First, the authors use three proxies to measure how long funds hold stocks in their portfolios. The main metric is fund duration. Next, they sort portfolios into 5 quintiles from low holding duration to high holding duration. Following this, the authors double-sort portfolios into 5 quintiles based on how active they are (the proportion of portfolio weights that do not overlap with benchmark weights). Finally, they generate a 5*5 double sorted table.

This paper also test two groups of funds: retail mutual funds and institutional portfolios. The below table shows the performances of 25 retail mutual funds.

  1. Regardless of active share, funds which trade frequently generally underperform their benchmarks.
    1. Specifically, based on fund duration sort, quintile 1 underperforms quintile 5 on all share quintiles.
  2. Among high active share portfolios, only those with high holding duration are able to outperform their benchmarks on average.
    1. The average outperformance of the most patient and active shares equals 2.3% per year, net of costs. Compounding from 1995 to 2013 generates a cumulative outperformance of 54%. On the other hand, The average underperformance of the most impatient and closet index funds equals –2.46% per year, net of costs. Compounding from 1995 to 2013 generates a cumulative loss of 38%.
25 double sorts table
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.
active patient funds win
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

What Factors Drive Outperformance?

In order to be better than average, we need to be different. In other words, the portfolio must have high active share. But a high active share strategy that buys growth stocks is simply going to underperform–a lot. We need to identify a process that actually exploits systematic behavioral problems.

We are personal fans of the CHEAPEST, HIGHEST QUALITY VALUE STOCKS. Guess what?

Active managers that outperform follow a similar process!

From the authors:

Their outperformance can largely be explained by their focus on stocks that other investors shun or find less attractive for their impatient strategies: 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.

Good luck!

 

 

 


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Definitions of common statistics used in our analysis are available here (towards the bottom)




About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.


  • Mark

    Any thoughts/ comments on the recent publication from AQR about Active share? feel like there is a bias for them to say that there is basically no value about active share due to their investment strategies. Anyway, here is the link:

    https://www.aqr.com/library/aqr-publications/deactivating-active-share

  • Michael Milburn

    One of the hardest things about investing, imho, is to just sit still. It’s difficult to simply leave a portfolio alone (although I think I recall studies that encourage more frequent rebalancing/turnover of a strategy for enhanced returns).

    The “market” seems to operate on a different, slower, time frame that’s difficult to appreciate, and difficult to learn from because feedback is both a) disjointed in time from the investment decision, and b) often contradictory/random (it’s easy to learn the wrong lesson).

  • Pingback: Quantocracy's Daily Wrap for 04/30/2015 | Quantocracy()

  • Doug01

    A stock holding period of at least 2 years is needed. A corollary of that is that the vast majority of options are irrelevant.

  • Yep, familiar with the paper and I think it adds to the discussion on active share. Simply being active doesn’t instantly create value. One needs to be active–and follow a process that works–otherwise you’ll be investing in concentrated garbage…also not a good investment approach.