Slow, steady tops fast trading on Wall Street

Date: Thursday, March 8, 2012
Author: Reuters

Today's coda for investing in the market calls for rapid-fire trading and an eye for the next hot sector. The investing heroes in this world are hedge funds such as Renaissance Technologies, which made founder James Simons a billionaire with its computer-driven, high turnover trading.

And yet, an informal study of U.S. mutual funds shows that managers who churn through their portfolios are underperforming those who hold investments for longer periods.

The hair-trigger trading strategies used by a number of hedge funds ran into trouble last year, when worries over the U.S. budget, European debt crisis, Japanese tsunami and North Africa unrest whipsawed markets and left investors frustrated over when to get in and out.

The mutual fund study, from Thomson Reuters' Lipper Inc, examined about 75 categories of funds over various lengths of time, finding that longer-held portfolios outdo about 70 percent of the time those funds holding stocks for only a short period.

Low turnover - less than 30 percent a year, or far below the historic average - often beats turnover that is four times greater or more, the data showed.

A longer holding period is a surprising antidote to the poor returns that plagued hedge funds last year. Many hedge funds are driven by fundamentals, but their holding periods are typically short - at times three days or less.

Hedge funds over the past decade turned over an average 35 percent of their positions every quarter at an annualized rate of nearly 140 percent, according to Goldman Sachs research.

SECRET SAUCE FOR ALPHA: LENGTHEN HOLDING PERIOD

Data from the New York Stock Exchange shows annual turnover has steadily increased for decades, peaking at an annualized 138 percent in 2008 during the financial crisis. It has since retreated to an annualized 74 percent in January.

A look at U.S. mutual funds found that portfolios with low turnover outperformed those with high turnover 70 percent of the time over various periods, according to data from Lipper.

About 75 categories of funds were examined at one-, three-, five- and 10-year periods, and at turnover ratios of 30 percent or less, 60 percent or less and 110 percent, a level now considered typical in the mutual fund industry.

Increased transaction costs and the selling of losers for tax purposes often drag on the performance of portfolios with high turnover, said Tom Roseen, head of research services at Denver-based Lipper.

"Very seldom do you see high portfolio turnover actually totally outperform," Roseen said.

The HFRI Fund-Weighted Composite Index of more than 2,000 hedge funds last year fell 5.13 percent, only the third calendar-year decline since 1990, according to Hedge Fund Research Inc of Chicago. The reinvested returns of the Standard & Poor's 500 Index .SPXTR gained 2.1 percent in 2011.

Lengthening the investment time frame in choppy markets will improve the results of investments, advocates say, but it requires a strong stomach to wait for the strategy to pan out.

"To actually add value to alpha, to outperform, you have to have a long holding period," said David Pearl, co-chief investment officer at Epoch Investment Partners Inc.

Epoch is unusual in that it typically holds stocks for about three years, far longer than most money managers. Pearl and co-CIO Bill Priest, with 76 years of experience between them, practice a dying art on Wall Street - security analysis. Fundamental analysis gets overlooked, but can outdo rapid-fire turnover when adhered to with patience.

The New York firm is wary of price-to-earnings or price-to-book metrics trumpeted on Wall Street, as they can easily be manipulated or hide value traps.

Epoch instead scrutinizes free cash flow - the amount of money left over after capital expenditures and all the bills are paid - to gauge a company's growth prospects.

Many investors prefer a story that promises future riches. But Pearl finds free cash flow remains the best measure for determining a company's health.

"When we see businesses that are growing but keep losing money, keep having to raise equity or borrow money, we know, eventually, they're going to be in trouble," he said.

Amazon.com Inc (AMZN.O), for example, trades at a P/E ratio of 130, far exceeding the average of 20.2 for Internet retailers, even though it is growing only twice as fast as the e-commerce sector has as a whole in recent years, according to Thomson Reuters data. Amazon is spending heavily to expand and warned in January that it may post a first-quarter operating loss.

And analysts have panned Microsoft Corp (MSFT.O) for a lack of new ideas, yet operating income has grown by double-digits the past two years.

"They're not getting credit for being technologically up-to-date," Pearl said of Microsoft, which Epoch holds. "It's a cash cow, and we argue they do know what they're doing."

Amazon's stock has gained about 35 percent since the end of 2009 after flat-lining for years. It's off about 26 percent from an all-time high in October. Microsoft rose 4 percent over the three-year span, but is up about 30 percent since October lows.

The market will eventually reward fundamental analysis if a company's profitability is improving and management rewards shareholders through buybacks, increased dividends or debt reduction, Pearl said - but only if cash flow is positive and growing.

Epoch's returns have consistently beat its benchmarks. The biggest fund - Equity Global Shareholder Yield with $6.5 billion in assets - has beaten MSCI's all-country world index by 5.3 percentage points before fees since its inception six years ago.

Epoch's assets under management rose to $19.2 billion as of December 31, up one-third from a year earlier.

After the subpar returns in 2011, hedge funds have outperformed so far this year in what has been an eerily quiet market. But many analysts warn uncertainty is likely to return with China's growth slowing and the still-unresolved euro-zone debt crisis encumbering the developed world.

"We definitely expect high-volatility, risk-on risk-off going forward because a lot of the big macro uncertainty has not been resolved," said Eric Weigel, director of research at the Leuthold Group in Minneapolis.

A high volatility environment that favored less risky assets snarled the timing of entry and exit points in 2011, making it difficult for thematic bets to pay off.

Since the financial crisis hit, the number of days with large swings has been greater than any time since the Great Depression. Swings of 2 percent or more occurred once in every seven trading sessions in 2011, data from research firm Crandall, Pierce & Co show.

"A greater proportion of players in the markets have really shortened their time horizon because it really is risky to make long-term bets, even though they may prove to be very rewarding in the long term," Weigel said.

"But nobody has the patience to wait that long."