Some of the world’s greatest investors such as Warren Buffett (Trades, Portfolio), Seth Klarman (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) are known for their long holding periods. These investors buy and hold stocks for many years, or in Buffett’s case, many decades as the investment theses play out, and they continue to profit from a well-run highly profitable business.
These investors have made billions over the years from a long-term strategy, and it is clear that long-term investing is the best way to build wealth. What’s mysterious is that, while this is well-known, many investors fail to follow this simple strategy.
Recently I discovered another mistake that all investors are apparently making; as a result it is seriously impacting their returns.
One big mistake
It is well-known that most mutual funds fail to outperform the benchmark over the long term. There's a prevalence of data showing mutual fund underperformance has led the huge shift away from active management to passive management since the financial crisis. There’s been such a seismic shift away from the sector in recent years that now the whole idea of a mutual fund seems far-fetched.
As it turns out, mutual funds have sponsored their own undoing and as more and more investors flow to passive instruments, mutual fund managers are accelerating the trend by trying to replicate the performance of passive strategies. The evidence that supports this statement comes from professor Martjin Cremers, who just released a new academic paper “Active Share and the Three Pillars of Active Management: Skill, Conviction and Opportunity,” which analyzes 25 years of mutual fund performance from 1990 to 2015.
This paper looks at several different traits of mutual funds and the most interesting is the performance of different mutual funds rated by their active share. Active Share measures the percentage of a fund’s portfolio that deviates from a benchmark. For example, an Active Share measure of 0% means the portfolio is an exact clone of a benchmark while a measure of 100% means there is no overlap with the benchmark at all.
As the performance of mutual funds has been eclipsed by that of index tracking passive funds at a lower cost for much of the past 10 years, mutual fund managers have moved toward so-called "closet indexing" as they try and build return similar to those of the index. However, Cremers' data shows that if anything, "closet indexing" only increases the fund manager’s chances of underperforming. Specifically, Cremers calculations show that the funds in the top quintile of Active Share demonstrated outperformance on average, producing 68bp of alpha. The other 80% of large-cap funds significantly underperformed by an average of over 100 bps per annum.
Furthermore, it’s not just the most intuitive managers that usually outperform. The laziest mutual fund managers with the longest holding durations performed significantly better than their more actively trading peers. Specifically, high Active Share managers with the longest holding durations outperformed their benchmark by 240bp on average, whereas the remainder of the high Active Share quintile averaged less than 30bp of outperformance.
Time to be lazy
There are several takeaways here for the average investor.
First, it doesn’t pay to try and follow the index; if you want to outperform find a fund that has its own opinions and chases stocks that are appealing based on internal calculations, not crowding or "closet benchmarking."
Second, if you want to outperform with your own strategy, moving in and out of positions will only hold back your performance. The best way to invest is to buy a high quality company in which you believe and hold it for the long term. This way there is also reduced risk that you will reinvest the proceeds into an underperformer if you take profits too early.
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