When Active Beats Passive Investing

Wesley Gray |

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Passive investing can be very effective because it tends to be low-cost and tax-efficient. 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.

In our research, we've found 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%.

Our main finding:

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

Other Key Findings:

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

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. Specifically, based on fund duration sort, quintile one underperforms quintile five on all share quintiles.
  2. Among high active share portfolios, only those with high holding duration are able to outperform their benchmarks on average. 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%.
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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.

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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 are the Factors that 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 of this study:

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!

For more from Wesley Gray and his investing and finance team, check out their blog at Alpha Architect.

 

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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