Trading is not a dirty word
A mutual fund which keeps portfolio turnover low may be simply a mutual fund which keeps missing opportunities.
A new study finds that active funds which trade more, rather than less, go on to outperform.
Perhaps in part because of the vogue for index funds, which trade as seldom as possible, there has been considerable focus on the virtues of keeping costs low by opting for funds which make their bets and stick to them.
While the logic of keeping costs minimal is integral to a passive investment strategy, having low turnover as a value, as such, may be less than useful in selecting active managers.
“We identify a new dimension of fund skill – the ability to tell when profit opportunities are better,” Lubos Pastor of The University of Chicago and Robert Stambaugh and Lucian Taylor of The University of Pennsylvania write in the study which is slated to be published in The Journal of Finance.
“Our finding that funds are able to successfully time their trading activity seems new in the literature.”
This successful varying of trading activity depending on conditions implies not only skill in securities valuation, but that the managers can, in the old phrase, “time the market”, perceiving and acting on opportunities.
A one-standard-deviation increase in the average turnover of similar funds brings with it a 0.43 percentage point increase in annual fund performance. It’s significant that average turnover of similar funds, which weeds out the effects of inflows and outflows, is predictive for returns even when you control for an individual fund’s turnover.
The important point is that the study tries to better capture trades which the fund chooses to make, rather than ones it is forced to make to accommodate new inflows or help fund sellers to cash out.
The survey considered data from US equity mutual funds between 1979–2011.
The study looked at the relationship between fund trading activity and three indicators which might suggest that there were mis-pricings in financial markets: investor sentiment, cross-sectional dispersion in individual stock returns, and aggregate stock market liquidity. When sentiment is bombed out, for example, stocks are often trading at attractive prices, as they sometimes do when prices are volatile or when there is low liquidity.
Just think about trading conditions at the height of the financial crisis in 2008 and 2009 – which in retrospect was a perhaps once-in-a-lifetime entry point for investors – to get an idea of the relationship between those three indicators and opportunity.
As an investor might hope, trading picked up when the market, using those three indicators, was functioning poorly at pricing.
Useful or better?
The less liquid a stock is, generally the stronger the relationship between turnover rate and performance improvement, according to the study.
“Funds holding stocks of small companies, or small-cap funds, have a significantly stronger turnover-performance relation than do large-cap funds. Similarly, we find a stronger relation for small funds than large funds, consistent with the ability of smaller funds to trade less-liquid stocks, given that smaller funds tend to trade in smaller dollar amounts,” according to the study.
This is driven, presumably, by the fact that a given trade in a small-cap stock impacts price more than it does for large-capitalization shares, implying that managers need a commensurately larger opportunity to justify the same trade.
If you accept that more highly skilled funds are able to charge more, something I’ve not always found to be the case, then it is reasonable to expect that there is a rising relationship between fees, turnover and performance.
“That is indeed what we find,” the authors write.
None of this settles the passive vs. active argument, and indeed the evidence remains strong for active.
As with earlier studies which find a negative relationship between turnover and truly active management – those funds which aren’t simply hugging benchmarks to avoid career risk, this study could be useful in choosing an active fund if that’s what an investor wants.
What the study does underscore is the useful role which active fund managers play in helping the market allocate capital efficiently. Active funds trade more when it makes sense to and thus drive prices closer to where they, by rights, ought to be.
By aiding price discovery – the act of figuring out what something really should be worth, active fund managers help both passive investors and the economy as a whole. With the share of US equities owned by passive investors headed towards half, that process may someday weaken to everyone’s detriment.
For now, passive investors are probably better off continuing to accept that free ride.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at email@example.com)