Swedroe: Trades Reveal Institutional Truths

Short-term trading hurts institutional performance.

With trillions of dollars under management, how well institutional fund managers perform is a topic of great interest to many. One reason is that institutional managers have some advantages, at least theoretically, over retail investors.

For example, they often hire professional consultants to help them perform due diligence in interviewing, screening and ultimately selecting the very best of the best investments. You can be sure these consultants have thought of every conceivable screen to identify the best fund managers.

Surely they have considered not only managers’ performance records but factors such as their management tenure, depth of staff, performance consistency (to make sure that a long-term record is not just the result of one or two lucky years), performance in bear markets, consistency of strategy implementation, costs, turnover, and so on. It’s unlikely you or your financial advisor would think of something they hadn’t already considered.

A Look At Performance

Bidisha Chakrabarty, Pamela Moulton and Charles Trzcinka contribute to the literature on the performance of institutional investment managers with their study, “The Performance of Short-Term Institutional Trades,” which appears in the August 2017 issue of the Journal of Financial and Quantitative Analysis.

Their data sample consisted of the daily U.S. equity transactions of 1,186 institutional money managers and pension funds present in a proprietary database for at least five years. It covers 105 million round-trip trades between 1999 and 2009, with a total volume of more than 291 billion shares. Following is a summary of the authors’ findings, some of which may seem surprising:

• Most institutional trades with holding periods of nine months or less lose money.
• The shorter the holding period of an institutional trade, the more negative the return of the trade.
• More than 23% of round-trip trades were held for less than three months. The raw returns on these trades averaged -3.9% (nonannualized). After adjusting for exposure to common factors (size, value and momentum), the risk-adjusted returns were still a highly significant -1.2%.
• The mean (median) two- to three-month trade returns for institutional money managers was -2.6% (-2.9%), and for pension funds -3.4% (-3.4%), both of which remain highly significant and negative on a risk-adjusted basis.
• The average raw return was still significantly negative for trades held less than two years, but becomes significantly positive for trades held longer than two years. The risk-adjusted return becomes significantly positive earlier—at the six- to nine-month holding period.
• Trading losses are pervasive across all types of stocks, with the lowest returns occurring in small stocks (where funds supposedly have an information advantage), value stocks and low-momentum stocks.
• Short-term trades lose more in more volatile markets.
• Across funds, the worst short-term returns accrue to those that do the most trading, and the funds that trade more often tend to have the worst negative short-term-duration trades.
• Among pension funds, those that have the highest percentage of short-term trades tend to have the lowest short-term trade returns.
• There is no evidence of persistent skill in short-term institutional trades. The only persistence of performance is among the poorest-performing funds, which are the ones that tend to trade the most.

As a test of robustness, Chakrabarty, Moulton and Trzcinka found qualitatively similar results when they used one month instead of three months as the cut-off for the definition of a short-duration trade. They also found that their results were not driven by the global financial crisis of 2008.

Question Of Holding Periods

Perhaps their most interesting finding, though, was that, on average, short-duration trades would have been profitable had they been held for a year instead of being closed out within three months. The authors hypothesize that this finding could be explained by recency bias.

This is the opposite of the disposition effect, which is the tendency to sell winning investments prematurely to lock in gains and hold on to losing investments too long in the hope of breaking even.

Chakrabarty, Moulton and Trzcinka noted that the high degree of short-term trading they found on the fund level was consistent with fund managers “trading to look active.” They also concluded their results demonstrate that institutional investment managers are not trading on superior information.

The results from Chakrabarty, Moulton and Trzcinka’s study are entirely consistent with the findings presented in my book, “The Incredible Shrinking Alpha,” in which my co-author Andrew Berkin and I showed that, because competition is getting increasingly more skilled, it’s becoming more and more difficult even for institutional investment managers to outperform appropriate risk-adjusted benchmarks. And if they find it difficult, with all of the resources at their disposal, it doesn’t seem likely the odds will be favorable for other investors either.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.