Long-term investors must understand that a well-considered, disciplined decision to exit a stock isn’t a breach of their philosophy. Second of two parts (read part one).
By Clare Flynn Levy
Clare Flynn Levy is CEO & founder of Essentia Analytics. Prior to setting up Essentia, she spent 10 years as a fund manager, in both active equity (running over $1bn of pension funds for Deutsche Asset Management), and hedge (as founder and CIO of Avocet Capital Management, a specialist tech fund manager).
In my last blog post, I mentioned an objection we often hear from managers who are reticent about working with Essentia: “I’m afraid it will mess with my process.” This post offers a real-life example of how thoughtful process improvement is critical to success — and doesn’t compromise your investment philosophy.
I recently sat in on an Essentia Insight Session with a client whose philosophy is very clear: it involves having a concentrated portfolio of companies with a certain common characteristic. I won’t get into what that is, for confidentiality reasons, but in practice, it leads his team to hold positions for years at a time. They identify as long term investors.
One of the key findings in Essentia’s analysis of his portfolio told him something that didn’t reconcile with that identity: they often held onto positions well past the point where those positions were making a positive contribution to his portfolio’s returns, and too many were becoming “round trippers” – they’d generate alpha, then give it all back.
If you’re a follower of Essentia’s research, you’ll recall that our Alpha Lifecycle research paper demonstrated how common “round tripping” is – and how it explains the struggle of active fund managers to outperform index funds, net of fees.
The “Round Tripper”: positions accumulate alpha early on, then give it all back (and then some) before the portfolio manager gets out.
Round tripping is a common affliction: between the conventional wisdom that long-term is “the right way” to invest, the fact that most asset allocators have their own long time horizons, and the good old endowment effect (which causes us to “fall in love” with the things we own), there are a lot of good explanations for it. But it comes at a significant cost to portfolio returns.
Round tripping IS avoidable. As our follow-up research, the Half-Full Glass, showed, the median manager’s median position made over 120bps of excess return before giving it back – and the manager had a very realistic window of 6 months to get out of the position in order to save almost all of that 120bps. We described to this portfolio manager how Essentia’s Alpha Decay Nudge has been proven to help managers do just this.
Window of Opportunity: The “Alpha Lifecycle” curve is in its top quartile for about six months in a typical one-year holding — and above 50% for about nine months. This implies a significant window of opportunity for managers to act while their positions are still producing alpha in excess of their fees.
But this portfolio manager wasn’t having it. “We’re long term,” he said. “We don’t want to mess with that.” He wouldn’t even consider trying the nudge.
Why would this be? The data was showing him that he had an opportunity to generate significantly better performance by making one small change to his process, and yet he was unwilling to consider doing anything about it.
My own theory is that the data, which was effectively saying that he should consider getting out of his winning positions sooner, was threatening his identity as a long-term investor. But was it, really? In his case, the analysis was suggesting that he put his positions through an extra set of objective questioning when they were three years old. That’s not exactly short term. Implementing that process improvement need not threaten his investment philosophy.
Putting identity to one side, in slightly more analyzable terms, he was saying “I’m worried this will cause us to start exiting too early.”
In practice, over the last eight years, we’ve seen no evidence that an Alpha Decay nudge (or any other nudge) causes managers to start exiting too early. That’s because a nudge is not a trading rule, and none of our clients treat it as one. What it is, is a prompt to execute an additional element of the manager’s decision-making process – to ask him or herself a few extra questions about the position, at a key point in time. The manager may well decide to do nothing – or even to double up.
This alpha lifecycle consideration is an additional step in the investment process, but that extra step does not undermine the investment philosophy – it doesn’t turn a long term investor into a short term investor. What it does do is prompt the portfolio manager to make certain decisions more deliberately than they may have done in the past.
How we know nudges work: We compared sells made following an Alpha Decay nudge being delivered to a client versus those that weren’t. On every major metric, the nudged trades performed significantly better.
If you’re wondering what happened to our obstinate client, he did come around, eventually, to the idea of receiving an Alpha Decay nudge. It took some time, some deep diving into the data evidence, and the support of other members of his team. But in the end, what cured the dissonance he was experiencing around his identity as a long term investor was the realization that his very long-term horizon is a byproduct of his philosophy – it’s not the philosophy itself.
This blog is the second part in Clare’s series on investment process vs. philosophy. Read part one.
