The magic ingredient turns out to be…wait for it…patience.
Several years ago, two Yale business school professors gave the personal finance industry a jolt by devising a formula for determining how active so-called actively managed mutual funds really were. What they discovered was that the portfolios of many mutual funds were so similar to their benchmarks that they might as well be considered closet index funds—in which case investors were paying higher fees for no good reason. These closet index funds tended to underperform their benchmarks, but funds with the least overlap with their benchmarks—those with the highest Active Share as defined as the proportion of holdings that is different than their benchmarks—on average outperformed their benchmarks net of fees, according to their analysis.
Now one of the inventors of Active Share has identified another very important trait of successful mutual fund managers: patience. In a recent paper, Martijn Cremers, now of University of Notre Dame, and Ankur Pareek of Rutgers, analyzed a large sample of actively-managed all-equity U.S. retail mutual funds over a 19-year period (1995-2013) and found that only those with both high active share and patient investment strategies, where managers hold stocks longer instead of trading frequently, tended to outperform by an average of 2.3 percentage points a year, even after management costs were taken out.
Historically investors have been able to partially measure a fund manager’s patience with the self-reported Fund Turnover Ratio, which is the ratio of all sales to buys in the calendar year over the number of fund shares outstanding. The lower the ratio, the less turnover in the portfolio, but the measure is still limited to a year. Now Cremers and Pareek have introduced a different measure, called Fund Duration, which measures the length of time the fund has held $1 of equities in the portfolio over the last five years in order to identify the most “patient capital.”
How patient is patient? The median holding duration in their sample of funds was 14 months, but those funds in the top 20% for Fund Duration generally held stocks for more than 24 months. Interestingly, Cremers and Pareek have found that fund duration on average has been steadily increasing since 2001, and turnover ratios have correspondingly declined.