Risk Adverse With Gains

Cashing in on winners generally feels right, but can represent an expensive form of risk aversion. This tendency to sell winners quickly is consistent with The Disposition Effect.

Cabot is working with a highly successful $2 billion Small-Cap, Growth Fund that has beaten its benchmark by 100 basis points annually for more than 5 years. The fund's strategy is bottom-up, fundamentally driven; turnover is 0.33 times per year for an average holding period of 36 months. The fund typically holds less than 50 positions.

This brilliant buyer is, however, giving back some of her hard-earned alpha through ineffective selling. In particular, she is selling winners experiencing a short-term run up in price (Positive Momentum)well before they have given their full value to the portfolio. Of course there are sound reasons to jettison winners early, two examples of which are (a) risk management – the trimming of positions when their portfolio weight exceeds some specified upper bound and (b) style drift – selling positions when their market capitalization grows from a Small-Cap to a Mid-Cap, necessitating a rebalancing. Upon careful analysis neither of these conditions appeared to be related to the selling of the positions in question.

This manager is now implementing a behavioral shift based on holding on to winners experiencing high short-term momentum for up to 33 months. Working with daily, stock-by-stock indicators, the manager is refining her fundamental sell discipline simply and powerfully. Pursuing this shift will enable the fund to realize approximately 82 basis points and 114 basis points of incremental return and alpha, respectively. The benefits from this shift are highly predictive based on excellent statistical findings from the "Out-of-Sample Testing" (P-Value <3 %).