It is unsurprising that “ active share has not been a reliable indicator of fund managers’ success” (“Active share revealed to have feet of clay”, Financial Times, January 26). Active share pioneer Martijn Cremers, professor of finance at the University of Notre Dame, never meant it to be such.
“Active share measures how different a portfolio is to its benchmark and thus the potential to outperform it. It is not a measure of skill and you do not need skill to have high active share, just a dart board and a small number of throws. Rather, active share helps to know which funds to consider, or where on the lake to fish,” he says.
Indeed, his latest research, “Patient capital outperformance: the investment skill of high active share managers who trade infrequently”, tells people how to catch the big fish after having made the logical decision to consider managers who are at least giving themselves a chance to outperform.
Prof Cremers’ finding is that among high active-share portfolios (whose holdings differ substantially from the holdings of their benchmark) only those with patient investment strategies outperform their benchmarks, by 2.3 per cent per annum net of costs.
The research goes on to note: “Funds trading frequently generally underperform, regardless of active share”. One might be tempted to think that this is just down to high trading costs eating into performance, but that would be a mistake. After all, the low trading costs for the active funds that were patient could not alone have been the reason for their good performance.
No, the point is that it is easier to predict asset prices over longer time horizons than shorter ones. Furthermore, the reality is that it is easier to predict the stock prices of a few companies than a larger number. There are, after all, only so many hours in a day in which to carry out the necessary analysis.
Of course, one would not put all one’s money in the stock in which one had the highest conviction, but that is where common sense comes in. I am sure the likes of Warren Buffett would be highly amused to see the industry fawning over research that says a concentrated, long-term approach is a good idea.
Contemporaries from the world of academia might share Mr Buffett’s amusement. Nobel laureate Professor Eugene Fama was one of the pioneers of the study of asset price behaviour. In the 1960s he reported that shorter-term stock returns were somewhat predictable from previous returns (they had a tendency to move in the same direction), but that the relationship was quite weak. Later, he stated that these patterns were so faint that attempts to exploit them would be wiped out by trading costs.
This “no-arbitrage” model formed the basis of the efficient market hypothesis. In the decades since Prof Fama’s early work, there have been countless other empirical studies published that looked for patterns in stock prices and markets. One might think that if stock prices are essentially unpredictable over short timeframes then they are even more unpredictable over longer ones. However, this is not the case. Indeed, it was Prof Fama himself who in 1977 showed that the short-term interest rate could be used to forecast the longer-term return on the stock market.
Later, in 1984, Nobel laureate Professor Robert Shiller showed that there was a positive correlation between the current dividend yield and subsequent returns. When the dividend yield was high, the subsequent one-year price movement was higher than normal, contrary to the efficient market model, which implied that “a high current yield should correspond to an expected capital loss to offset the current yield”.
Prof Fama showed in a 1988 paper that dividend yields had even greater predictive power over longer timeframes. While dividend yields explained 15 per cent of subsequent one-year returns, over five years they explained 60 per cent.
These early and well-regarded studies support Prof Cremers’ findings. But then, does it not intuitively make sense that high conviction, long-term managers produce good results? Most investors tend to be overly fixated on short-term performance. One would be better advised to focus on the longer term — you will be fishing in less competitive waters.
Peter Elston is global investment strategist at Seneca Investment Managers
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