"The problems start when so-called long-horizon managers play the short-term game"
Should we be surprised to learn that some active equity fund managers have higher portfolio turnover rates than they themselves claim? Or might we have expected that an emphasis on short-term investing is no longer particular to day traders, arbitrage funds and those whose time horizons are short by design?
The news that investment managers are overestimating their investment horizons and underestimating turnover for their portfolio suggests a systemic issue for which there are no easy answers. But this information - contained in a new report examining the investment horizon of long-only active equity portfolio managers between June 2006 and June 2009 - at least forces us to look at the problem. And when nearly two thirds of long-only equity institutional investment products have turnover that exceeds expectations, it's time to explore the reasons and the possible solutions.
The report ‘Investment Horizons - Do Managers Do What They Say?', conducted by Mercer consulting and commissioned by the not-for-profit IRRC Institute, deployed two approaches to the research. First, a quantitative analysis of the portfolio turnover of more than 900 strategies examined the expected and realised average holding periods for various investment products across different regions and styles. Mercer then conducted a qualitative case study analysis of eight active equity fund managers whose turnover had exceeded expectations by a considerable margin, to find out why.
The key findings of the quantitative analysis were dramatic. Nearly two thirds of the strategies examined have turnover higher than expected, with some strategies recording more than 150-200 percentage points higher turnover than anticipated. Of the 822 strategies for which Mercer had both expected and actual turnover information, 550 exceeded the expected turnover during the sample period, with average turnover 26 percentage points higher than anticipated. And within the entire sample of 991 strategies, the average annual turnover of the sample was 72%, with 20% of strategies having annual turnover greater than 100%.
More specific details emerged as well. For example, value managers tend to have a lower annual turnover figure than the other style types, large capitalisation portfolios have lower turnover rates than small capitalisation strategies; and socially responsible investing (SRI) strategies have lower turnover than non-SRI strategies. Across the regions, UK, Canadian and Australian equity strategies have the lowest average turnover value, while European (including UK), international and US strategies have the highest average turnover levels.
For investors in such products, the findings should cause concern. When portfolio managers greatly exceed their expected turnover level, the impact can be significant in terms of cost, performance and overall risk that the strategy is not being managed in line with its stated investment approach. While not always the case, deviations in actual versus expected turnover could be a possible indicator of deeper problems with investment processes. There may be good reasons for increased trading, but for clients interested in a strategy that seeks to capitalise on longer-term trends and to hold stock in corporations for longer periods, the excess trading fundamentally changes the investment strategy the client thought it was buying. Clients have the right to be aware if the product is morphing, and why.
To some extent, the ‘why' emerged from the report's qualitative case study analysis, as told by the portfolio managers themselves. Among the causes of their short-termism - defined as an average holding period of 12 months or less, or in more relative terms, a higher actual level of turnover than expected levels as self-reported - were volatile markets and changing macroeconomic conditions, mixed signals from clients, short-term incentive systems, and behavioural biases.
Importantly, these fund managers recognised the potential destructive nature of short-termism, even while claiming it was unavoidable. They indicated that short-termism potentially places short-term pressure on companies to the detriment of long-term shareholder value, increases market volatility, could demonstrate a lack of discipline in the investment processes, and creates a misalignment of interests between fund managers and their clients.
These discussions with fund managers also identified some mechanisms to extend the investment horizon and minimise the risk of significant and sustained overshoot in turnover versus expectations. For example, a range of unsolicited ideas were raised by the managers about what regulatory measures might be considered to promote longer investment horizons. Perhaps because some believe that "long-termism is not capitalism", they feel that regulatory oversight is necessary to extend the market's focus further into the future.
Then there is the issue of incentives. To varying degrees, fund manager annual bonuses are linked to performance versus a benchmark or manager rankings table in any given year (with some attempting to measure and weigh this over a three-year period). Most managers felt that the manager ranking/league tables in particular created a short-term mindset and hence would not be a desirable feature for long-horizon mandates.
Another theme that emerged was the belief that longevity of client relationships encourages managers to stay true to their process (including investment horizons). One manager noted that because his team had been around for a long time and had client relationships that span a full economic cycle, they it felt less likely that the bulk of their clients would drop them for short-term market underperformance.
Almost all the managers argued the importance of being clear about the investment horizon and how that fits into the process from the outset. One manager in particular - who appeared to stay within his expected turnover range over volatile periods - noted that in all pitches with clients his team emphasised that the portfolio would look very different from the benchmark and, in doing so, they hoped to attract like-minded end investors that are also focused on the long term.
Clearly, there is a role for all types of investment strategies - including short horizon approaches which can help to provide market liquidity, exploit short-term mis-pricings and improve overall market efficiency. However, the problems start when so-called long-horizon managers play the short-term game, particularly when their clients are none the wiser that this is how their assets are being invested.
There is further research to be done, including an exploration of cause and effect, and the behavioural finance evidence suggesting that investor psychology and speculative investment activity contribute to higher asset price volatility, creating a vicious cycle of asset price volatility and short-term horizons.
In the meantime, however, the research is plain and some remedial steps can be taken today: two-thirds of the institutional products turn over more than the managers intend. That suggests that to be on top of the potential risks from investing in actively managed long-only equity funds, institutional investors would be wise to explicitly consider the investment horizon as an additional barometer of fund manager style and process in their selection and evaluation of managers - and be ready to investigate the reasons why a strategy has strayed from its stated horizon.