How Some Active Managers Successfully Time Their Trading

For individual investors, trading more is generally a bad idea. The more you trade, the more you spend on fees and other trading costs.

But the same is not true for active mutual-fund portfolio managers. Research suggests that active managers perform better when they trade more. Managers seem to know when it’s a good time to trade.

Chicago Booth’s Lubos Pastor and the Wharton School’s Robert F. Stambaugh and Lucian A. Taylor followed manager performance over time. They find that when an active portfolio manager trades more than usual in a given year, exceeding the fund’s average level of trading, he generates higher returns the following year. This suggests that active managers recognize market inefficiencies and are able to capitalize on those inefficiencies by making bets that often result in gains.

The researchers—who studied a sample of 3,126 active US equity mutual funds from 1979 through 2011—also find that smaller funds can more easily increase trading when they see market inefficiencies to better exploit those opportunities.

“Our interpretation is that smaller funds are more nimble,” Pastor explains. For example, when a $50 billion fund decides to trade even 1 percent of its portfolio, it’s shifting $500 million from one stock to another; and buying that much of anything is going to move the price. “Smaller funds are not concerned about this, so smaller funds can adjust their turnover freely over time,” Pastor says. “But bigger funds find it more difficult to trade more because they move prices when they trade.”

Prices also move when large numbers of investors are buying or selling the same stocks at the same time—so when funds act en masse, the positive trading results weaken. In other words, trading more is better, but only if the rest of the market isn’t moving with you.

This means that those active managers who are especially skilled at finding inefficiencies others don’t see will have the best performance. So if you’re trying to select an active manager, the best choice might be the contrarian thinker who trades more than usual.