Self-proclaimed investors typically look down on mere traders, but this arrogance may be misplaced.
In a new study of fund managers’ behavior, Mohammad Irani and Hugh Kim of the Darla Moore School of Business at the University of South Carolina present evidence that ‘buy and hold’ may not be the best approach.
Irani and Kim investigated institutional investors’ 13F filings of their quarterly equity holdings between March 1980 and June 2013 to construct what they called an ‘inertia ratio’.
This reflected trading activity within each manager’s portfolio, specifically the proportion of stock positions that were not touched each quarter, adjusted for events such as share splits and de-listings. The researchers ended up with a sample of almost 6,000 unique institutional investors and more than 28 million portfolio observations.
Their headline discovery was that, on average, these institutional investors did not trade a single share in approximately 25% of the companies they owned in any given quarter. However, there were some dramatic spikes in activity after the crashes in 1987 and 2008.
There was also a consistently wide gulf, averaging 27 percentage points, between the top and bottom quartiles of managers by inertia ratio, indicating a persistent split between frequent traders and steadfast ‘buy and holders’ in the population.
Don’t just sit there, do something!
So which group performed better? Looking first at only the underlying stocks, Irani and Kim reported that the most inert quintile of managers’ positions produced average monthly excess returns of 2.3%, but the least inert quintile generated 6.6%. This outperformance by the heavily traded stocks was statistically significant, and the pattern was similar on a five-alpha model too.
‘Taken together, our findings suggest that inertia stocks held by institutional investors are likely to underperform, which may undermine the overall performance of institutional investors,’ Irani and Kim summarized.
Indeed, they calculated that an increase of one standard deviation in stock inertia was associated with a reduction in returns of between 1% and 1.7% per annum.
The authors also ruled out some possible explanations for this trend. For example, they excluded companies with share prices below $5 to control for the effects of penny stocks and micro caps, but still documented a correlation between high inertia and lower risk-adjusted future returns. The same was true for other measures of illiquidity accounting for the inertia in certain stocks.
In fact, diving deeper into the attributes of the inert stocks, Irani and Kim noted that they were not positively correlated with price-to-book ratios either and had lower momentum loadings.
‘These characteristics are not consistent with the conjecture that institutional investors just buy and hold stocks for extended periods to benefit from value premiums and momentum premiums,’ they commented.
Rather, the typical inert stock in a manager’s fund had a smaller market capitalization, higher valuation, more volatility, greater leverage and lower profitable than average. The academics therefore surmised that ‘institutional investors are likely to choose inertia for stocks with high information uncertainty’; that is, it is not the solid blue chips they prefer to buy and hold, but the riskier names – either because of or despite the difficulty of forecasting their performance.
Intriguingly, though, the results at the stock level were not replicated at the fund level: Frequently traded holdings outperformed those that were left alone, but managers with lots of inert positions did not lag those who regularly turned over their portfolios.
One interpretation is that managers derive their returns primarily from those stocks that they concentrate on and trade actively, but that they also still maintain a tail of holdings that they neglect but which do not detract from their overall performance.
‘Institutional investors may optimally allocate their attention to other stocks to trade and make more profits from those traded stocks,’ Irani and Kim suggested.
‘Taken together, these results suggest that institutional investors focus on a group of stocks for trading but incur losses from not trading inertia stocks. Although they may need to allocate more attention to some stocks for trading, they can increase their overall performance by understanding the adverse effect of inertia stocks.’