The ketchup principle

Billionaire investor Seth Klarman has argued that “the single greatest edge an investor can have is a long-term orientation.” This trait, however, is in short supply. Not enough investors are patient enough to hold stocks where the rewards may be a long time in coming.

A limited supply of patient capital then ensures that stocks which repel short-term investors will be attractively priced. These may be stocks with recent underperformance or high idiosyncratic volatility, meaning they fluctuate more than some investors can stomach.

Investment discourse is rife with such claims and of course anecdotal evidence (I’m not at a loss for a couple of in-house examples). Research confirmation has been less abundant, but that’s been changing in later years. One contribution intriguingly nuances the concept of active share, claimed to be an important dimension of active management performance. The idea is that a high active share is associated with better performance, while a low active share rather describes a closet indexer where the fees kill net returns.

It now looks like the outperformance is critically related to patience. Excess returns are only harvested by funds with patient investment strategies, as defined by trading frequency – duration in excess of two years. Funds with a higher trading frequency deliver negative excess returns, even if they have a high active share.

A related paper looks at holding horizon, calculated as the value-weighted average of the holding period of stocks held by the fund – and presents its conclusions in no uncertain terms.

First, long-horizon funds outperform short-horizon funds at all investment horizons (one month to five years). Second, stocks held by these long-horizon funds turn out to deliver superior returns over the next five years. Adjusted for risk, the difference amounts to 2.7% – 3.5% per year. And third, this difference seems related to fundamentals. These stocks score well on metrics like cash flow news and earnings estimate revisions.

Then, in September this year, two Columbia University researchers posted yet another confirmation on the Social Science Research Network SSRN. They have a different definition of horizon – the weighted average number of consecutive quarters a firm is held by active institutional investors, compiled from investment manager filings.

But they have a similar conclusion, confirming that horizon is indeed a significant predictor of returns: a 1% increase in horizon translates to around 20 basis points (bps) of monthly returns – and it’s significant to boot. Furthermore, it is not subsumed by traditional return factors typically used in such testing, such as value or momentum. In this case, emphasis is on stock returns and not fund-level returns.

What could possibly cause such a high return premium? In a clever twist, they utilise what one might call a natural experiment: a 2004 rule by the US Securities and Exchange Commission which increased disclosure frequency. This change clearly reduced investment horizon and demonstrated that more interim monitoring made investors more myopic. In turn, this increased the measured return impact of a longer horizon by more than 60 bps per month.

In contrast, improved access to machine-readable filings had no effect. So it wasn’t just about better access to information.

As it happens, myopic behaviour among institutional investment managers is well documented. They face constant threats of redemptions or career setbacks, so have to prioritise shorter-term results. This leaves room for more patient investment managers who can – perhaps by virtue of more patient investors – exploit the higher returns from long-horizon investments.

And remember, where higher volatility causes some stocks to be unpopular, the higher return on these stocks is not likely due to higher risk. Empirically, higher volatility is in fact associated with lower returns, not higher. In a sense, then, you can have your cake and eat it too.

You just have to be patient at the serving counter.