Active share is a measure that tells you something about the potential of a fund to outperform its benchmark. It is not, however, a performance predictor. But Cremers, who presented his research at the annual Morningstar Investment Conference in London on Wednesday, suggests that high active share does give managers a better chance to outperform, provided they hold on to their positions for at least two years on average.
“Patient high active share managers outperform both in large and small cap funds,” says Cremers, currently a Professor of Finance at the University of Notre Dame in the US. Managers who have an active share of at least 90% and average holding period of at least two years, have average outperformance of 2% per year, Cremers writes in his working paper Patient Capital Outperformance.
Other high-active share managers do not outperform their benchmarks more often than their less active peers. So why would patience be a predictor of outperformance?
A simple explanation could be that patient managers incur fewer trading costs, but this is quickly dismissed by Cremers as it couldn’t possibly explain the entire performance gap. The longer time horizon these managers focus on gives us more of a clue, he believes.
“Successful active managers succeed in identifying temporarily undervalued stocks. But it’s very difficult to do that over a short-term horizon, because markets are not efficient over short time periods,” the Dutchman explains. This automatically gives more patient stock-pickers an advantage. “The average holding period for a US equity fund is 1.5 years, while I qualify more than two years as patient.”
Given that patience apparently is a proven virtue for investors too, have managers actually been shifting to employing more patient strategies? They have to some extent, says Cremers, as the average period managers hold stocks has actually been on the increase in recent years. However, this is, rather ironically, mostly due to the rise of so-called benchmark-huggers. “Most patient funds are in the lowest active share quintile,” says Cremers.
There are several reasons there are relatively few patient, high active share managers, according to Cremers. “Patient managers need to have the nerves and confidence to tolerate longer periods of underperformance that can last up to 1.5 years,” he says. “And perhaps even more importantly, they need to have the trust of their investors. If underperformance leads to outflows, the manager is forced to sell, meaning he can’t implement his patient strategy. This all makes it harder to run a patient, high active share strategy.”
As to illustrate his point, a survey by Legg Mason published this week shows that only 38% of UK retail investors would tolerate more than 12 months of underperformance. This means the vast majority will sell a fund if it underperforms for longer than that.
Cremer’s research also suggests a positive relationship between performance persistence and the length of the track record among high active share managers. “A long track record will help to reassure investors entrusting their money with a high active share manager,” he says. And it’s worth noting here that it takes patient managers more time to build a track record as they trade relatively little. “Therefore, managers with a long track record are more likely to be able to execute a patient strategy successfully,” Cremers concludes.