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Three fascinating lessons overlooked by investors

Investing is a field where experience matters a great deal. And, yet, we’re all prone to biases and leaning into heuristics that may not have strong empirical underpinnings. That’s why it is important to stay current with the latest research in our field, challenging our own beliefs in the process.

There is no shortage of literature on behavioral economics and asset allocation. In the holiday spirit of distilling things down, though, here are seven studies that I thought presented fascinating insights. Even better, almost all of them are from the past few years -- in other words, not the Markowitz paper you read about at university -- tucked into three specific themes.

1. Funds managed by a single manager tend to perform better

That was one of the key conclusions from a study published in 2016 by the Financial Analysts Journal. The authors - Goldman, Sun, and Zhou - identified some intuitive yet unappreciated results:

“...we identified the organizational design behind the loss of abnormal returns associated with less concentrated portfolios. In particular, we found that mutual funds run by a single manager tend to have a much higher portfolio concentration, both across and within industries, than funds run by multiple managers.”

The traditional narrative is that two heads are better than one, and no doubt there are many situations where that is the case. What the authors found, though, was that more heads lead to more diverse portfolios that likely dilute the value added by the individual portfolio managers’ highest-conviction holdings.

It is hard to overstate how diluted down these portfolios can get. The authors looked at 35,253 U.S. mutual fund portfolios and found that the average number of holdings was 144 positions. This is way beyond what is necessary to capture the benefits of diversification - 86% of possible tracking error is reduced with just 30 holdings, according to a 1999 study by Sturz and Price - and may help explain the widespread phenomenon of most active managers underperforming after fees and expenses.

The authors weren’t sure whether there were other factors in play. For example, multi-manager funds tend to have larger asset bases than single-manager funds, so maybe the issue was less about portfolio dilution and more about size-driven headwinds. They also discovered:

“We further found that when funds’ management designs are changed from single manager to multiple managers (or from multiple to single), portfolio concentration decreases (increases) and performance deteriorates (improves).”

The study also has unflattering conclusions regarding older funds run by long-serving managers.

2. Active management can add value when it is actually active 

Not all active management (active as in not passive) is very active. Morningstar’s Caquineau, Möttölä, and Schumacher found in Europe that 20.2% of the European large-cap funds they studied had a three-year average active share below 60%. In other words, the funds were closet indexers.

Research suggests managers with higher active share on average better those with low active share (the closet indexers). A 2017 study by Lazard Asset Management’s Khusainova and Mier found that, when global and international funds were split into quintiles based on active share, the best-performing quintile was that with the highest active share while the worst-performing quintile was the one with the lowest active share.

Given that the previously discussed study found that portfolio concentration was aligned with performance, that may not be too surprising. And yet, many investors do not make this distinction when discussing active management.

An even more interesting twist into active share is that Cremers and Pareek found in a study published in the Journal of Financial Economics that high active share alone was not indicative of outperformance. The authors found only portfolios with high active share and patient holding strategies (holding durations of over two years) delivered outperformance.

3. Australia’s home bias is off the charts

Home bias is a global phenomenon, however, the magnitude of Australia’s home bias is astronomical compared to similar Western markets. A Vanguard paper that I recently highlighted notes that the value of listed Australian equities makes up only 2% of the global market and yet Australians collectively hold 67% of their portfolios in Australian shares.

Granted, there are some good reasons for Australians to be overweight their home country - franking credits and a long history of economic excellence being key among them - but the 65% gap dwarfs that of the UK (19%) and US (29%).

What makes the outsized home bias gap even more puzzling is that Australian equities have a lower unhedged long-term correlation to international equities (0.58) than the UK (0.66) and US (0.76). In other words, Australians have historically reaped far more bang for their diversification buck from diversifying into global equities than the UK and US and yet our home bias is far, far stronger.

 

Joe Magyer is the Chief Investment Officer of Lakehouse Capital, a sponsor of Firstlinks. This article contains general investment advice only (under AFSL 400691) and has been prepared without taking account of the reader’s financial situation. Lakehouse Capital is a growth-focused, high-conviction boutique seeking long-term, asymmetric opportunities. 

For more articles and papers by Lakehouse Capital, please click here.

 

4 Comments
Joe Magyer
January 08, 2020

Hi Howard. The different study results aren't mutually exclusive. The majority of active managers underperform their benchmarks net of fees, however, on average the ones that are most likely to outperform are those with high active share.

Ben
December 19, 2019

Interesting, thanks for some more biases to be aware of and think about...

(-) It's funny that the Cremers/Perek study found best performance for active managers with long holding times, because at first read that sounds like an oxymoron! My first image of an "active" manager would be closer to a trader than a holder of shares. This almost sounds more like a combination of active stock picking with "passive" stock holding?

(-) With respect to the Australian home bias, wasn't there a study at one point that compared AU and US stock markets, and found that in the long term, both were almost equivalent? I want to say something like 9.5% and 10% respectively. So as you say, global diversification might have been a benefit, but those numbers are both still pretty nice! Add that to the dividends/franking credits situation, and the cost/difficulty of investing globally (perhaps brokers
and global funds used to be fewer in number, with higher costs and fees), and I'm not really surprised by the continuing home bias.

Joe Magyer
January 08, 2020

Hi Ben. On active vs. passive, I'd note that 'active' here doesn't speak to trading activity but rather than the manager is making active allocation decisions as opposed to passively mimicking an index.

On the home bias, it is true that the long-term returns of the US and Australian markets are broadly comparable, however, the correlation to international equities (0.58) suggests investors have historically significantly reduced portfolio-level volatility through international diversification without sacrificing a great deal in terms of total returns. It is also worth noting that Australia's returns are juiced by such a long stretch without a recession, a situation that will change at some point.

Howard
December 19, 2019

How do the statements on active management marry with the S&P (SPIVA) data which shows 75% of active managers underperform the index after fees.

 

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