Research reveals shortage of patient capital

Investors demand returns – and many of them want them to happen overnight. But not every investment opportunity has this kind of potential. Some take years to bear fruit, but yield big results when they do.

Mutual fund managers often choose not to add stocks like these to their portfolios, even when they know they exist. This is because fund managers are motivated to plan for the short term by the structure of their reward packages and the day-to-day obligations of managing the mutual fund.

But research from Rafael Zambrana of the University of Notre Dame argues that mutual fund fee structures can be created to stimulate long-term thinking, and this leads to better outcomes for investors who have the patience to commit their capital.

“In the ’60s, investors held stocks for an average of eight years. Today, the average is only six months,” says Zambrana, assistant professor of finance at the Mendoza College of Business.

“This figure includes securities held by institutional investors such as mutual funds. When institutional investors such as hedge funds engage in high-frequency trading, they are touting a short-term investment horizon. This seems to be what investors are asking for in the asset management industry and the lack of patient capital.” .

Fund managers’ compensation is often based on their performance relative to a benchmark and is usually measured over a short period of time. This could be one year or even less, and fund managers are incentivized to consider this timeline. Concerns about their performance evaluation can influence their decisions. They may choose not to buy some stocks because they will not perform well in the short term.

Fund managers also need to consider investor behaviour. Initial investors in mutual funds can withdraw their money at any time, and fund managers need to provide it to them when they do. This means that managers may need to sell shares to pay investors, and that makes profitable, illiquid shares less attractive. The most liquid stocks can easily be bought and sold with the least impact on their price. If the fund manager needs to sell them quickly, it won’t cause the share price to drop much.

In “Capital Commitment and Performance: The Role of Mutual Fund Fees,” in Journal of Financial and Quantitative AnalysisZambrana proposes a model that analyzes the performance of mutual funds with different sales fee structures. The research finds that fee structures that incentivize fundamental investors to be patient with their investments allow fund managers to take better advantage of longer-term opportunities, especially stocks with lower levels of liquidity. This ultimately makes investors more money.

“The main challenge for portfolio managers is misalignment with the investment horizon of value investing,” Zambrana says.

“Even if they think a stock is undervalued and will go up, they may not want to add it to their portfolio because of the short-term commitments of fund management. We argue that the desire to invest in the long term should be rewarded. We call that committed capital, which is It provides insurance for portfolio managers, so you should reward it.”

When individual investors buy shares in a mutual fund, they are placing their trust in a fund manager who manages the fund’s assets with the goal of beating the market. To get this service, the underlying investors pay a fee. These fees are usually charged annually, but by pre-loading the fee, mutual funds can attract more investors over the long term.

When a higher fee is charged at the time of investment, and a discount is offered on the annual fee, there is less incentive for people to withdraw their money, because they have already paid more than their fee. This helps prevent outflows of funds caused by cashing out the primary investors. It also allows fund managers to secure more capital in good long-term investments, such as companies that rely heavily on research and development or invest in tangible assets such as real estate. Shares in these companies are sometimes likely to go up in the long run, but it’s hard to sell them quickly.

In Zambrana’s model, funds with large upfront fees outperformed funds with higher annual fees.

“Patienced capital is the source of outperformance,” Zambrana says. “Mutual funds with plenty of it can take more risk. It allows portfolio managers to invest in less liquid stocks.”

“It’s not really a concern that they would struggle to sell, because they wouldn’t need to sell in the short term. That leads to better returns. Fund managers can invest for longer, waiting until the capital is invested. The underlying mechanism is that patient capital allows portfolio managers to Leveraging their skills to beat the market.