Getting an Edge from Sticking Around
How a long-term ethos helps the American Funds.
Many fund managers say they buy stocks for the long term, but in reality, they rarely stick with a company for long. The typical mutual fund turns over 83% of its portfolio annually, suggesting a holding period of about 14 months. At the American Funds, however, the average rate of portfolio turnover for its funds is 29%, so the firm's managers usually stick with a stock for more than three years. This month, I'd like to focus on American's less-frequent trading and portfolio turnover because I think it constitutes a significant part of the firm's edge over its competition.
Why Funds Trade
First, low turnover, by itself, probably isn't a competitive advantage because nothing prevents other investment organizations from copying it. Similarly, managers are not forced to churn the stocks in their portfolios. After all, it's not as if portfolio managers go to work each day and are required to buy and sell stocks.
But there are powerful incentives in place that may encourage a manager to trade. Many managers' bonuses are computed on the basis of their shorter-term performance: say, one, two, or (at best) three years, or some combination thereof. In fact, only about half of the fund companies we analyze for Morningstar's Stewardship Grades for mutual funds pay their fund managers primarily based on performance over periods longer than four years. By emphasizing shorter-term performance periods, managers are less likely to think of themselves as long-term investors or business owners; instead, they're compelled to try to capture shorter-term movements in stocks. Managers more interested in short-term price movements of stocks than longer-term business prospects are naturally discouraged from buying out-of-favor stocks. Even if their analysis shows the stocks are cheap relative to the longer-term value of the underlying businesses, the stocks may not turn around quickly enough to personally pay off for the fund manager.
So, instead of buying low and viewing further price declines as still-better buying opportunities, managers avoid stocks that seem like problem children. Managers with short-term performance goals want to buy what's "working," and what's working changes on a day-to-day, if not a minute-to-minute, basis. As a result, managers don't invest slowly and methodically, but trade haphazardly and sometimes frenetically, with their annual bonus on the line.
There may even be something about a mutual fund's structure, including its daily pricing and liquidity features, that encourages fast trading. For example, I recently heard a fund manager say that he and other managers were judged on a weekly and even daily basis. While it's true that daily pricing makes it possible to judge funds against each other on a weekly and daily basis, it seemed to me as if the daily pricing feature of funds encouraged him to judge his own performance according to an unrealistic time frame.
Short-term incentives also cause managers to construct portfolios that look very similar to indexes in the hopes of squeezing out slight consistent victories over most of their competitors or the index. In a rather tepid attempt at differentiating themselves, managers will own stocks that are leaders in a major index even if they're not bullish on the company, but they'll own the stock in a lower proportion than their index weighting. Managers will also trade "around" positions, alternately boosting them and decreasing them relative to the index and their peers based on short-term expectations and liquidity because they're fearful of underperforming for a quarter or a year. In effect, they sacrifice the attempt to excel over the longer haul to achieve tiny gains every quarter.
Tiny, consistent gains can add up, but they usually don't materialize from this effort. What's important to professional managers, however, is that big relative losses don't materialize either. As long as a manager looks roughly like the index and his peers on a consistent basis, his job security stays intact. And there you have the warped ethos of most professional investors: The biggest sin--and the surest way to be handed a pink slip--isn't modest long-term underperformance compared with an index or your peers but radical short-term underperformance that results from looking substantially different from the index or your peers.
How American Discourages Turnover
So, if short-term thinking encourages a kind of built-in bias favoring turnover, what can break the bias? Why is American different? One easy way to break the bias is to impose a bonus system based on a longer-term performance time frame, and this is exactly what American has done. The bonuses of American's investment professionals are based on four-year performance results. Second, the firm encourages collaboration by having parts of the bonus based on the overall performance of the organization. Even if absolute performance is down, bonuses can increase if American's funds outperform relevant indexes and peers over longer time frames. Third, according to Charles Ellis' book Capital, American's employees have nearly $1 billion of their own money invested in their defined-contribution plan, which consists of the same retail funds that 20 million shareholders own; American's employees eat their own cooking. Fourth, ownership in Capital Research by many of its investment professionals also provides long-term incentive. According to Ellis, more than 350 people have an ownership stake in the business and are, therefore, concerned with its long-term success. All of these factors give American fund managers (and even rank-and-file employees) plenty of incentive to act with long-term results in mind.
But paying employees on longer-term investment results won't automatically persuade them to avoid trying to post a string of short-term victories. It's not that economic motives aren't important, it's that they don't always work as intended, or can have different consequences than those intended. For example, someone being paid on the basis of four-year results may become too discouraged to stick with a strategy if it isn't succeeding by the end of the second or third year. So what else makes American different?
The crucial factor in American's success is that an ethos or culture of long-term business value pervades the organization. My suspicion is that the ethos precedes the four-year-results rule precisely because other institutions are free to impose the rule but choose not to, or impose similar rules but don't have the same results. The heart of American's competitive advantage, therefore, is an approach to investing that seeks to capitalize on the long-term ownership of businesses purchased for less than they're worth. To use famed investor Benjamin Graham's parlance, American Funds has a willingness to be well-"served" by the market's periodic insanity by purchasing businesses from it for less than they're really worth rather than be "instructed" by it by accepting its prices or the short-term trend in price movements as the truth about a stock's value. As former American Funds portfolio manager Bob Kirby remarks in Capital, "The market is screwy most of the time," and American is an organization built around trying to exploit the insanity.
This long-term business-ownership ethos is American's competitive advantage because, although one can understand it fairly easily, it's a habit even very smart human beings can't seem to practice easily across an entire investment organization. It's usually established only by the organization's founder (in American's case, Jonathan Bell Lovelace), and almost as a rule, exists only in organizations whose sole purpose is investing rather than in investment organizations that are parts of banks, insurance companies, or other financial institutions. Investment outfits operating under different principles seem to be able to do nothing to acquire the long-term, low-turnover ethos; it either exists from the beginning or it probably never will.
So turnover is low in American's funds because the managers and analysts know they will be paid for their longer-term performance and also because they believe in the principle that they can exploit the market's dislocations over longer periods of time. Consequently, American's managers sell stocks only when they think their original theses about them were wrong or when the stocks rise above the managers' fair value estimates. In the latter case, this process can, but typically doesn't, happen overnight. One's patience is often tested severely, making low turnover uncommon.
What Low Turnover Produces
Low turnover, which, as I have argued, is one part of a larger approach to investing, allows American to exploit market dislocations or "screwiness." If you're investing in out-of-favor stocks, it may take the market a while to realize what you already see about them or for the market to recover its senses and remember what it knew all along. Having patience and sticking to your holdings allows you to exploit the market's emotional lapses, which can last for a few years sometimes.
Low turnover, combined with American's multimanager approach, may also contribute to American's ability to manage the amount of assets that it does as effectively as it does. Warren Buffett has said repeatedly that size is a detriment to investment results. Size prevents one from exploiting what are potentially the greatest discrepancies in price and value in stocks because one can move the price of stocks easily in building and reducing positions, resulting in purchases at high prices and sales at low ones. Still, American's penchant for holding stocks for three or more years on average allows it to enter and exit positions in large stocks gently enough, without gyrating prices. We're always on the lookout for a fund's size hindering its performance, but we haven't seen it at American yet, and we think that American's low portfolio turnover, combined with its willingness to buy what others are selling and vice versa, is at the center of its success.
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