Have you noticed that share prices really start to move around earnings season? It makes sense, though. As a company’s performance fluctuates, so too does the demand for their stock.
If profits exceed expectations, an investor jumps in and hope for more growth to come. If profits disappoint, an investor is quick to sell. I’m generalising of course, but these are the usual the reactions you’ll see.
US investors are now well into their second quarter earnings season. A stand out winner has been Netflix, Inc. [NASDAQ:NFLX]. The company added 5.2 million new members. That was far more than the 3.23 million Wall Street was expecting.
The stock jumped 9% on the day, and is up 51% year-to-date (YTD). And it’s not just Netflix that’s outperforming. As reported by CNBC:
‘As of Friday, 73 percent of S&P 500 companies that had reported beat earnings estimates and 77 percent topped sales estimates, according to data from FactSet.’
Time to top up on US stocks?
The fund manager’s dilemma
Imagine I gave you $50,000 to invest. But there’s a catch. Each quarter I would review your performance. If you didn’t beat your benchmark, the ASX 200, then I would take $10,000 away from you.
What would your strategy be?
Would you try to buy undervalued stocks that might take a year or more to appreciate? Or would you jump in and out of ‘hot’ stocks, trying to capture short-term gains?
You’d probably lean towards the latter right? It makes more sense to try and ride the ‘hot’ stocks in the short-run, to beat your benchmark for the quarter.
Well, this is the situation many fund managers are in.
Unlike an individual investor, funds are encouraged to invest in stocks that will appreciate in the short-term. If they don’t, they’re at risk of investors selling out and going somewhere else.
Because of this emphasis on the short-term, funds usually have high portfolio turnover rates. Meaning they change their holdings often. I suspect its these high turnover rates that leave a ‘professional’ investor with less than professional returns.
The lazy fund manager usually wins
Let’s talk about turnover rates for a moment. To give you some context, a turnover rate of 100% means the fund has replaced their entire portfolio within 12 months.
Now, take a guess at what the average mutual fund turnover rate was in 1998? I’ll wait…
According to DOW Publishing, it was around 93%. Meaning they held stocks for a little over a year. Yet this is nothing compared to the top 25 most active managers at the time.
Turnover rates among the most active managers ranged from 215% to 972%, averaging a turnover rate of 320%. This equated to holding periods of 24, 5 and 16 weeks respectively.
I’ll ask the obvious question. Does all this activity actually improve returns? Simple answer, no.
Take a look at the graphs below.
Source: Marotta on Money
[Click to open new window]
Both charts show the relationship between turnover rates and returns for 407 mutual funds. The top chart is over a three year period, and the bottom is over a five year period.
As you can see, funds with the lowest turnover rates performed far better than the rest. The reason why, to my mind, comes down to two factors.
First, holding undervalued stocks for longer periods should theoretically give them more time to appreciate. Second, fund managers who had lower turnover rates — those who traded less — likely made fewer mistakes.
Thus, the lazy fund manager sits on his investments beat the most active manager trying to optimise his portfolio.
Since 1998, funds have caught onto the idea of inactivity. As a result, their turnover rates have declined. According to the Investment Association, the average fund had an asset-weighted turnover rate of around 40% from 2012–15.
But why not reduce it to 10% or even 5%? If inactivity increases returns, why not wait for great businesses to go on sale, and then hold them for years?
As I mentioned before, many fund managers aren’t terribly focused on the long term. And that’s because their investors are far more interested in what returns they’re generating in this quarter and the next.
DOW Publishing points out that activity in itself could also be comforting to many managers.
‘One cynical, but plausible, explanation is that active trading is the mutual fund manager’s “raison d’être.” If an inactively traded mutual fund does well, it may be concluded that the manager’s services were superfluous; if it does poorly, the manager will be blamed for inaction. On the other hand, if an actively traded fund does well, the manager is a hero; but, if it does poorly, it can be said that the manager at least tried.’
Use your edge
In a letter to shareholders, Warren Buffett wrote:
‘Inactivity strikes us as intelligent behaviour. Neither we nor most business managers would dream of feverishly trading highly-profitable subsidiaries because a small move in the Federal Reserve’s discount rate was predicted or because some Wall Street pundit had reversed his views on the market. Why, then, should we behave differently with our minority positions in wonderful businesses?’
I bring this up is because Australia is about to head into our own earnings season. Aussie investors are upbeat, and waiting to see if we will follow in the footsteps of the US. You can bet analysts will be changing their forecasts based on short-term performance.
I urge you to remember activity does not lead to higher returns. Jumping out of low growth and into high growth does not lead to higher returns in the long run. In fact, the opposite is more often true.
As Buffett explains:
‘The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries. In each case you simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved.’
Contributing Editor, Money Morning