The Case for Active Trading

Skilled investors at smaller funds can overcome transaction costs to earn high returns, researchers argue.

More frequent trading could boost returns—at least for the right fund size.

Although research has shown that high-frequency trading detracts from retail investor performance, some institutional investors actually outperform as a result of active trading, according to finance professors Jeffrey Busse (Emory University), Lin Tong (Fordham University), Qing Tong, and Zhe Zhang (Singapore Management University).

“Skillful trade execution can enhance an investment fund’s return relative to the competition,” they wrote. “Active trading has the potential to generate alpha if it can take advantage of opportunities in the securities markets.”

But lack of skill, the authors warned, could result in “excessive transaction costs and lagging performance. Only traders with skill can afford to bear the transaction costs associated with active trading.”

For the study, the researchers examined the performance, transaction costs, and trading frequency of asset managers and asset owners from 1999 to 2009 using data from trading cost analyst Ancerno.

Frequent trading among institutional investors, they found, was tied to higher risk-adjusted returns net of transaction costs: The highest-frequency traders outperformed the most static group by 0.73%. 

However, this gap narrowed as funds grew larger and generated higher transaction costs.

“Given that larger funds trade larger orders, they are susceptible to greater price impact from their trades,” the researchers explained. “Larger funds consequently realize lower net returns when they attempt to exploit short-term trading opportunities.”

Perhaps due to these higher costs, Busse, Tong, Tong, and Zhang found that larger funds exhibited lower trading frequency than their smaller peers.

“While it is difficult to argue with the idea that expenses should be minimized,” they concluded, “our evidence suggests that more expensive strategies can sometimes dominate, insofar as the most active institutional traders persistently produce positive abnormal returns.”

Read the full report, “Trading Frequency and Fund Performance.”

Related: High-Frequency Trading: Winner Takes All?