Last week my column looked at research showing that managers are more adept at buying stocks than selling them, with new purchases outperforming existing holdings over the ensuing 12 months.
In the paper, “Selling Fast and Buying Slow”, the researchers found that sales that occurred on days without earnings announcements fizzled. In effect, the stocks that the managers rejected would have been among their stronger performers.
But when Morningstar’s researchers have studied fund flows, they have generally found the opposite effect.
That is, funds that receive high cash flows typically disappoint. If portfolio managers are indeed adept at buying stocks, then heavy inflows should have benefited them, by spurring them to make purchases. That has not been so. Whenever Morningstar has examined the subject, we found that US equity funds that are flooded with cash subsequently perform worse, not better.
It’s not difficult to reconcile the two sets of findings. For example, it may be that fund flows are a signal, not a cause. Fund investors time their transactions badly, both by buying hot funds that invest in overbought sectors, and by selling cold funds that are primed for a rebound. By this hypothesis, fund managers didn’t create the results; their shareholders did.
Selling by Rule of Thumb
The central puzzle is why investment managers seem to be better buyers than sellers: managers think long and carefully about what new investments they will purchase, but not so long, nor so carefully, about what they will sell. Their sell orders, in contrast, are likely to come from rules of thumb, as it were.
As guesses go, these strike me as sound. Portfolio managers are by nature studious and that is generally how they approach their buy decisions. They purchase stocks not on whims, but instead because they think they have learned enough about a company to have an advantage over other investors. Which, if the Selling Fast report is to be believed, holds true.
They do not seem to prepare as thoroughly for their sell decisions. The Selling Fast paper finds that when unloading a stock, investment managers are influenced by its past returns. They are significantly more likely to move stocks that are either their very best or very worst performers. There is no such pattern with their buys. Apparently, managers who would never purchase a stock because of its price return are quite happy to consider technical analysis when selling.
While I am convinced by Selling Fast’s central argument, that professional stock managers tend to sell fast and buy slow, I am wary of its final supposition. As the authors acknowledge, it is strange that the non-announcement sales fare poorly. If managers lack skill when divesting their holdings, then one would expect a null result. But the managers perform worse than neutral. Their sell decisions actively hurt them.
This implies that the discarded stocks possess characteristics that make them strong future performers. The researchers think that may occur because, in addition to watching their stocks’ returns, managers are likely to trade stocks that they think about most frequently. These are likely to have been their best investment ideas. Thus, managers inadvertently damage their funds by giving up too quickly on their best-researched holdings.
