In my article just published in the top finance journal, JFQA with two co-authors, David Gallagher and Peter Gardner, we show that firm performance considerably improves following informed trading and “price discovery” by Australian fund managers.
For the first time, we identify informed trades as sequences of trades such as “buy” followed by a “sell”, and then a subsequent “buy”. We dub these, “swing trades”.
The top echelon of Australian fund managers participated in this study in an unprecedented way by revealing their daily trades to us as researchers.
This kind of close cooperation is almost unprecedented, especially as in Australia there is no provision for compulsory revelation of portfolios. The United States requires quarterly snapshots for large fund managers.
Surprisingly, we show that our sample of fund managers was able to predict successfully relatively short-term changes in stock prices.
These trade sequences with frequent changes in direction are not simply mindless churning, as the critics maintain, since they are profitable even after transactions costs.
In fact, active funds make their money for investors by over-weighting stocks in their portfolio for which they actively trade.
The mechanism by which this informed trading raises firm performance is enlightening.
Prior to these trade sequences, information asymmetry is high, meaning that it is risky for uninformed investors to trade as those taking the other side of their trades are likely to be highly informed.
Following these trade sequences, not only are market spreads significantly lower, but stock prices now more closely align with the CEO’s actions.
This greater responsiveness to the CEO’s actions means that the very limited “skin in the game” of Australian CEOs is far more effective in disciplining poorly performing managers.
It is this disciplining role, actively discouraged by the ASX Governance Council, which results in the subsequent firm out-performance.
Unlike index-funds, active fund managers generate liquidity that is sadly declining in the ASX market. More importantly, by undertaking price discovery and informed trading, they drive stock prices to fundamentals.
Contrary to widely accepted views, a more efficient secondary stock market results in better investment decisions and greater wealth in the pockets of Australian investors and retirees.
Active fund managers are a crucial part of this process and as a result deserve our encouragement.
Peter Swan is a professor of finance at the University of New South Wales.
This article was originally published at The Conversation. Read the original article.
