Portfolio managers exhibit herd mentality. They’re secure when their portfolios look just about like everybody who invests with the identical mandate, as nobody loses his or her job due to common efficiency or holding the identical securities as the remainder of the peer group.
Herding turns into extra pronounced in the direction of the top of the 12 months when portfolio managers window costume to spruce up their portfolios by promoting shares which might be obscure and have fallen in value and shopping for up shares which have accomplished effectively and are seen and within the public eye. On the similar time, portfolio managers lock in good efficiency by promoting dangerous shares (whom they purchased initially of the 12 months) and transferring to decrease danger shares in hopes of a greater Christmas bonus.
Window dressing and remuneration-motivated portfolio rebalancing, exacerbated by herding, impacts costs and returns of monetary securities all year long in a predictable approach. Dangerous shares are bid up (secure shares are bid down) initially of the 12 months, whereas low danger shares are bid up (dangerous shares are bid down) in the direction of 12 months finish. The sample repeats yearly, mimicking window dressing and/or the annual efficiency analysis cycle of portfolio managers.
Such seasonal behaviour is troublesome for the markets to completely get rid of for 2 causes. First, it’s associated to window dressing and/or remuneration-motivated turn-of-the-year portfolio rebalancing by skilled portfolio managers who pursue their very own curiosity year-in and year-out. Second, seasonality isn’t constantly noticed yearly. Except we now have a unified principle to assist us anticipate such seasonal behaviour on a constant foundation, market contributors can’t absolutely arbitrage the seasonal behaviour of monetary securities.
Traditionally, it has been remuneration-motivated portfolio rebalancing that largely impacted fourth quarter and January inventory returns. Within the final two months of 2022 and the primary month of 2023, nonetheless, such behaviour has been strengthened by extraordinarily lively window dressing by professionals and additional augmented by robust tax loss promoting by particular person buyers. Tax loss promoting is a technique that includes promoting shedding shares and utilizing the capital loss to offset any capital features incurred within the tax 12 months.
Window dressing by portfolio managers and tax-loss promoting by particular person buyers had a terrific affect on this 12 months’s file excessive January inventory returns, notably these of NASDAQ inventory returns which rose by over 11% in January, one of many strongest January returns on file.
Desk 1 may also help us perceive what occurred over the previous couple of months. It reveals the return and quantity to shares for the worst performing shares (these with the very best incentive for tax loss promoting) in S&P 500 and Nasdaq for 3 durations: March to October 2022 (regular buying and selling interval), November to December 2022 (tax loss promoting interval) and January 2023. Each indices skilled sharp losses between March and October 2022, particularly Nasdaq. Common (each day) quantity to shares excellent had been 1.6% for S&P 500 and 10.5% for Nasdaq.
The extreme inventory market losses over the March-October 2022 interval supplied a strong incentive to skilled portfolio managers and particular person buyers to make use of a tax loss promoting technique over November-December 2022. In consequence, each indices skilled additional losses within the interval with an uptick in quantity to shares excellent, up 8.75% to 1.7% for S&P 500 and up 64.8% to 17.3% for Nasdaq, denoting markedly elevated buying and selling vs. earlier months of the 12 months (i.e., the conventional buying and selling interval).
In January, as recession fears subsided, portfolio managers began to lift the chance stage of their portfolios by going aggressively after riskier shares and fewer so after decrease danger shares. This buying and selling exercise was strengthened by these professionals and buyers who went again to the market to purchase again the shares they’d bought for tax loss functions within the earlier months. This led to a supercharged “January impact”, notably for Nasdaq shares that skilled a pointy improve in costs (up 50.2% in January) and quantity (up 150% in January in comparison with March to October and up 52% in comparison with November to December quantity to shares). Whereas the S&P 500 quantity to shares didn’t change a lot because it consists of bigger and safer shares, Nasdaq inventory costs and quantity exploded.
It’s instructive to match the efficiency and quantity to shares of the riskier Nasdaq shares with these of three secure S&P 500 shares, specifically Johnson and Johnson, Procter and Gamble and Colgate Palmolive. In Desk 2 we see that the January quantity to shares of those shares didn’t change a lot from March to October on condition that there was not a lot of an incentive to make use of a tax loss promoting technique on this case. These shares outperformed the broader market in November-December and underperformed it in January, according to portfolio rebalancing.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Worth Investing on the Ivey Enterprise Faculty, College of Western Ontario.
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