Here’s How Active Managers Squander Alpha

New research shows that active managers do in fact generate alpha, but have a hard time keeping it because they hold positions too long. This according to an article in Institutional Investor.

The study comes from Essentia Analytics, a firm that examines fund manager decisions based on behavioral science. The article reports, “The firm found that for all the hype about active manager underperformance, these managers actually do generate alpha ‘well in excess of the fees they charge,’ the firm found. The problem: they tend to give all of it back, and then some, by holding on to their positions too long.”

The study involved analyzing about 10,000 “episodes”, or full cycles of a given position from entry to exit, across 43 portfolios over a period of 14 years. It found that “alpha starts out strong and fades sharply with age.” Essentia argues that the tendency is born of the endowment effect—a concept in behavioral finance that refers to the tendency to overvalue owned objects.

According to the research firm’s founder Clare Flynn Levy, this presents an opportunity for active managers to become more disciplined about exiting positions at or near the peak of their alpha curve: “They don’t have to roll over and die; they can do something to stop themselves from giving up the alpha.” The research shows further that portfolio managers don’t have to find the perfect time to sell, either. The article explains, “they can gain significant alpha by making decisions about their stocks in a six-month window.”

Flynn Levy notes that the research runs counter to what many people think. She says, “You can be a victim of being a long-term investor if you’re not careful.”