So much is made of the cost advantage of low-cost indexing that there’s a danger of forgetting its behavioural advantage.
Behavioural biases and natural human emotions are bad for returns, and as we’ve shown before, it’s harder for active investors to stay the course than it is for passive investors. Truly active funds, as opposed to closet trackers, have to diverge from the index. Indeed, the more genuinely active the strategy is, the more likely the fund will be to underperform its benchmark by large margins and for long periods. This data clearly shows us that most active investors simply won’t tolerate that sort of performance.
But it’s not just ordinary investors’ behavioural and emotional biases that are the problem. Professional investors — active fund managers, for example — are prone to them as well. So even in cases where the investor behaves perfectly rationally, the irrational behaviour of the manager can still have a negative impact on their returns.
A new study called Stock Repurchasing Bias of Mutual Funds sheds new lights on manager biases. Mengqiao Du and Alexandra Niessen-Ruenzi from the University of Mannheim and Terrance Odean from UCal Berkeley set out to investigate whether the emotional association that managers have with particular stocks that they’ve either bought or sold in the past makes them any more or less likely to buy those stocks again.
“Selling a stock for a gain,” the authors hypothesise, “is associated with positive emotions such as pride and happiness, while selling a stock for a loss is associated with negative emotions such as regret and disappointment. In an effort to repeat the positive emotional experience and avoid the negative one, mutual fund managers may be more prone to repurchase a stock that they sold for a gain (i.e. a past ‘winner’), while they may be less prone to repurchase a stock that they sold for a loss (i.e. a past ‘loser’).”
Du, Niessen-Ruenzi and Odean tested this theory by investigating a large data set of quarterly US mutual fund holdings from 1980 to 2014.
What they found
Their findings can be briefly summarised as follows.
Managers were, on average, 17% more likely to repurchase a stock if they had previously sold it for a gain rather than a loss
The effect was less pronounced if, after they sold stock, its price increased, which may have caused them to regret selling it in the first place
Managers were more likely still to repurchase a stock they previously made a gain on if its price fell after they sold it
Even when a manager moved to a different fund, they still preferred to repurchase stocks that they sold for a gain at the fund they managed before
Group thinking exacerbated repurchasing biases, so funds managed by a team of managers were more biased than funds managed by an individual
The likelihood of a stock being repurchased did not increase in line with the profit the manager made when they sold it. But the higher the loss a manager made on selling a stock, the less likely they were to repurchase it — an asymmetry which might be attributed to loss aversion
This is not the first time that academics have demonstrated bias in active managers. Previous research, for example, has shown that, like ordinary investors, managers are prone to biases such as home bias and overconfidence.
This is, however, the first study to show the bias that managers have towards repurchasing stocks that they previously sold for a gain rather than a loss.
The authors conclude:
“Our results are important for investors delegating portfolio management to actively managed funds, by highlighting that mutual fund managers are subject to behavioural biases, too.
“Investors may be better off investing in a passively managed fund that, by definition, does not engage in this type of trading behaviour.”