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Investing is a field where experience matters a great deal. And, yet, we’re all prone to biases and leaning into heuristics that may not have strong empirical underpinnings. That’s why it is important to stay current with the latest research in our field, challenging our own beliefs in the process.
There is no shortage of literature on behavioral economics and asset allocation. In the holiday spirit of distilling things down, though, here are seven studies that I thought presented fascinating insights. Even better, almost all of them are from the past few years -- in other words, not the Markowitz paper you read about at university -- tucked into three specific themes.
That was one of the key conclusions from a study published in 2016 by the Financial Analysts Journal. The authors - Goldman, Sun, and Zhou - identified some intuitive yet unappreciated results:
“...we identified the organizational design behind the loss of abnormal returns associated with less concentrated portfolios. In particular, we found that mutual funds run by a single manager tend to have a much higher portfolio concentration, both across and within industries, than funds run by multiple managers.”
The traditional narrative is that two heads are better than one, and no doubt there are many situations where that is the case. What the authors found, though, was that more heads lead to more diverse portfolios that likely dilute the value added by the individual portfolio managers’ highest-conviction holdings.
It is hard to overstate how diluted down these portfolios can get. The authors looked at 35,253 U.S. mutual fund portfolios and found that the average number of holdings was 144 positions. This is way beyond what is necessary to capture the benefits of diversification - 86% of possible tracking error is reduced with just 30 holdings, according to a 1999 study by Sturz and Price - and may help explain the widespread phenomenon of most active managers underperforming after fees and expenses.
The authors weren’t sure whether there were other factors in play. For example, multi-manager funds tend to have larger asset bases than single-manager funds, so maybe the issue was less about portfolio dilution and more about size-driven headwinds. They also discovered:
“We further found that when funds’ management designs are changed from single manager to multiple managers (or from multiple to single), portfolio concentration decreases (increases) and performance deteriorates (improves).”
The study also has unflattering conclusions regarding older funds run by long-serving managers.
Not all active management (active as in not passive) is very active. Morningstar’s Caquineau, Möttölä, and Schumacher found in Europe that 20.2% of the European large-cap funds they studied had a three-year average active share below 60%. In other words, the funds were closet indexers.
Research suggests managers with higher active share on average better those with low active share (the closet indexers). A 2017 study by Lazard Asset Management’s Khusainova and Mier found that, when global and international funds were split into quintiles based on active share, the best-performing quintile was that with the highest active share while the worst-performing quintile was the one with the lowest active share.
Given that the previously discussed study found that portfolio concentration was aligned with performance, that may not be too surprising. And yet, many investors do not make this distinction when discussing active management.
An even more interesting twist into active share is that Cremers and Pareek found in a study published in the Journal of Financial Economics that high active share alone was not indicative of outperformance. The authors found only portfolios with high active share and patient holding strategies (holding durations of over two years) delivered outperformance.
Home bias is a global phenomenon, however, the magnitude of Australia’s home bias is astronomical compared to similar Western markets. A Vanguard paper that I recently highlighted notes that the value of listed Australian equities makes up only 2% of the global market and yet Australians collectively hold 67% of their portfolios in Australian shares.
Granted, there are some good reasons for Australians to be overweight their home country - franking credits and a long history of economic excellence being key among them - but the 65% gap dwarfs that of the UK (19%) and US (29%).
What makes the outsized home bias gap even more puzzling is that Australian equities have a lower unhedged long-term correlation to international equities (0.58) than the UK (0.66) and US (0.76). In other words, Australians have historically reaped far more bang for their diversification buck from diversifying into global equities than the UK and US and yet our home bias is far, far stronger.