As investing professionals, active portfolio managers ought to be familiar with the behavioural and cognitive pitfalls that underpin bad decisions. But it turns out that they may be falling prey to one of the most prevalent and harmful biases.
According to new research from Essentia Analytics, a firm that analyses the fund managers’ decisions based on behavioural science, active managers are actually able to generate alpha “well in excess of the fees they charge.” The problem, however, seems to be that they relinquish those gains and more as they refuse to let go of their once-winning positions.
Over a sample of 43 portfolios, the firm evaluated approximately 10,000 “episodes,” each tracking the full cycle of a position from first entry to last exit within a span of 14 years. The analysis uncovered a trend that “alpha starts out strong and fades sharply with age.”
“Investors often hold on to positions too long (a consequence, we believe, of the endowment effect), diminishing or eliminating whatever excess returns they were able to generate early on,” the report said, referring to a tendency for people to overvalue an object already in their possession.
The finding may be hard for stock-pickers to swallow, particularly as they face continued competitive pressure from index funds that have done well for over a decade. But it does offer a path forward.
“There is an opportunity there,” Essentia Analytics founder Clare Flynn Levy said in an interview with Institutional Investor. “They don’t have to roll over and die; they can do something to stop themselves from giving up the alpha.”
Reining in their self-sabotaging behaviour can be difficult, particularly as it will involve a conscious effort to override an unconscious inclination, but the potential upside is not insignificant. Those who rein in their over-attachment to stocks can generate alpha of 1.2% annually on average at the portfolio level — large enough to translate into benchmark-beating performance after an average fee of 75 basis points.
The key, Levy said, is to be disciplined about exiting positions at or near the zenith of their alpha trajectory. “Once you know your pattern, and when your ideas tend to run out of alpha, you could get an automated reminder that says, ‘Be careful, the relationship is over,’” she said. “People have a tendency to wait too long, and then it turns nasty and they get divorced.”
The difficulty for fund managers, she explained, is that they are more inclined to give the benefit of the doubt to positions that have made money. But once they get out of the habit of asking hard questions about those holdings, it can open the door to losses in the long run.
Looking at top-performing managers provides a hint on the best approach. Across the study’s entire sample of fund managers, the average time spent holding on to an idea was 275 business days. But among the top quartile in terms of alpha generation, the average holding period was 133 business days, or six months.
“So you have a six-month period where if you get out in that period you would have preserved some, if not all, of the alpha,” Levy said. “But if you wait longer, historically we’ve seen all the alpha go away.”
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