Transparency is about as popular on Wall Street as on Pennsylvania Avenue, but it may be just as vital in both locations.
Mutual funds typically disclose their holdings only on a quarterly or at best monthly basis, but what if managers were required to be a lot more open about their trading?
Three academics at the University of Edinburgh’s business school – Marcel Lukas, Arman Eshraghi and Jo Danbolt – explored this question in the context of the disposition effect. This is the tendency of investors to sell their winners too early and to cling to losers for too long.
Plenty of evidence has been documented proving this behavioral bias, along with several theories to explain it. One is loss aversion: there is only about half as much satisfaction in realizing a gain as there is displeasure in taking an equal loss, so investors are quick to book profits and irrationally patient with paper losses.
Another hypothesis is cognitive dissonance: investors have to justify stock purchases to themselves and are reluctant to accept they were wrong if the shares subsequently tumble.
Many high-profile managers will spring to mind when Lukas, Eshraghi and Danbolt observe that ‘while only paper losses occur, investors can convince themselves that their actual belief is right and that the current adverse price movement is part of a temporary mispricing by the market.’
These authors investigated such topics through a novel dataset provided by Wikifolio, an online trading platform where investors publish portfolios that can be bought by other people.
Wikifolio shared anonymized information on almost 14,000 of these managers, with the researchers focusing on those who run traditional long-only equity portfolios and excluding those who had made fewer than 10 trades.
A crucial part of the study was that Wikifolio has a three-step process for investors: at first they can manage only a private portfolio that cannot be seen by anyone else; they can then opt to publish that portfolio publicly, whereupon it cannot be deleted and all positions and trades are transparent; and finally they can choose to open their portfolio to public investment, provided the manager attracts interest from other users and verifies their identity. This meant private and public investing behavior could be distinguished.
Lukas, Eshraghi and Danbolt’s key discovery when parsing the trading data from all these portfolios was that during the final and most transparent phase, the disposition effect in managers was almost 50% lower.
Sunshine is the best disinfectant
‘This implies that once portfolio managers trade in public and are aware of potential observers, they significantly reduce their disposition effect and therefore are likely to improve their performance,’ the academics summarized.
‘Our findings have important implications for practice and theory,’ Lukas, Eshraghi, and Danbolt concluded. ‘We find significant evidence that the level of transparency and limited ability to justify holdings reduces the disposition effect. Since we know that the disposition effect is wealth destroying, applying these findings in practice can improve the performance of financial managers.
‘This implies that financial managers can benefit from making their activities more transparent and reporting their holdings more frequently. Surely, doing so will also benefit the investors and allow for better governance in the asset management industry.’
Just as surely, professional managers will object to the extra scrutiny. A more practical step may then be to push for more oversight inside fund groups, specifically as the disposition effect relates to clutching loser stocks for too long.
A separate dimension to this issue links to the active-versus-passive debate: other work has shown that index investors are more prone to the disposition effect than those holding active funds. This suggests that when the mutual fund underperforms, the ‘delegation of failure’ from the investor to the manager makes the investor more willing to cut their losses.
Enhanced transparency could perhaps therefore have two beneficial effects on fund managers. It may improve their performance in the first place by alleviating the disposition effect, and it may also make investors more tolerant when losses do occur by aligning them more closely with the portfolio.