Avoid investment funds with higher investment portfolio turnover
The problem with high turnover is that higher fund trading adds substantial hidden expenses that drag down returns.
Because short-term trading is a zero sum game (before costs) played against other well informed traders, greater turnover is far more likely on average to result in lower fund returns instead of superior risk-adjusted performance. When trading is greater, then even higher returns are required just to break-even on the higher associated trading costs.
Higher bond and equity mutual fund turnover indicates that fund management is more active in buying and selling. Higher turnover indicates the usually futile pursuit of better short-term returns. The manager hopes that his presumably superior short-term speculative insight will allow him to beat others in our highly competitive securities markets. However, the higher costs of these strategies tend to overwhelm any performance improvement.
The primary impact of higher turnover is to drive up trading costs, which are not directly visible to individual investors.
These trading costs include brokerage commissions, the bid/ask spread, and negative market impact. Negative market impact results when a fund’s high trading volume exhausts the supply of currently available trade orders in the market, which causes the market bid-ask spread itself to move against the fund trader temporarily. To absorb this excess trading volume the bid/ask spread must shift to induce other investors to enter the market and trade. However, once the fund’s excessive trading volume is absorbed by the market, the bid/ask spread tends to shift back. By increasing the costs of buying and selling, negative market impact reduces the fund’s reported performance even before the management expense ratio is deducted.
Commissions, bid/ask spread, and negative market impact costs are not detailed in the information that is made easily available to mutual fund investors.
These trading costs are not paid out of the more visible expense ratio of the mutual fund or ETF, but instead they directly reduce the reported gross returns on a fund’s asset portfolio. (For information on a scientific study of mutual fund trading costs, see: How much do hidden mutual fund trading expenses cost you?)
The turnover ratio of a fund serves as a more visible proxy measurement for these hidden trading costs.
When compared to funds of a similar style, a fund’s turnover ratio gives a good indication of fund activism. Scientific finance studies indicate that lower turnover is simply better from the perspective of an individual investor’s net returns. Certain fund styles are characterized by very low turnover, such as index funds, and certain styles, like aggressive equity growth funds, will have far higher turnover.
If the fund screening application that you use allows you to screen on turnover, turnover will probably be calculated as a percentage of the fund’s average portfolio asset value that is turned over every year. Annual percentage turnover can range from a single digit percentage to a percentage that is many times 100%. For points of reference, here are average mutual fund turnover statistics from Morningstar.com for major types of funds.
As of January 2007, domestic stock funds had average turnover of 95% and international stock funds had turnover of 76%. Taxable bond funds had average turnover of 156%, while municipal bond funds had turnover of 29%. Over time, these turnover averages shift somewhat, but the changes tend not to be very substantial.
Mutual funds and ETFs have certain structural differences that may affect how the costs of trading are allocated among shareholders.
Nevertheless, highly active mutual funds and investors who are active in buying and selling ETFs both can incur substantial portfolio trading costs related to their investment strategies. However, with high turnover mutual funds, all shareholders pay the cost of both portfolio management hyperactivity and turnover costs of related to investors buying and selling mutual funds shares. With mutual funds, longer-term buy-and-hold shareholders in effect subsidize some of the costs of those who enter and leave more frequently. This is true even without the effects of recent mutual fund late trading scandals.
With ETFs, entering and leaving shareholders pay the full cost of their transactions via the bid/ask spread and brokerage commissions. Further details on these differences are beyond the scope of this article. However, if you want to understand more about the differences between mutual funds and ETFs, look at Gary Gastineau’s ETF Consultants LLC website. You can easily find more pretty sites on the web, but they will not have the depth of information on ETFs that Gary Gastineau provides. Start with “Frequently Asked Questions About ETFs,” then scan “Publications.”
Personal Financial Planning
- Screening Index Mutual Funds with IndexUniverse.com (Screening index mutual funds on-line with IndexUniverse.com
In this article, The Skilled Investor discusses how to screen index mutual funds on-line. This article focuses on using the free index mutual fund screener and database available at IndexUniverse.com.
We also discuss how to apply our seven scientifically based mutual fund screening criteria.
In a previous article, The Skilled Investor [...])
- Fidelity Contrafund (FCNTX) gains a +5 Fund Authority Score (
The diversified investment fund strategy of the Fidelity Contrafund (FCNTX)
According to its prospectus filing on the U.S. Securities and Exchange Commission EDGAR system, the investment strategy of the Fidelity Contrafund is to invest primarily in common stocks and particularly in the "securities of companies whose value Fidelity Management & Research Company believes is not fully [...])
- Dodge and Cox Stock Fund (DODGX) picks up a +8 Fund Authority Score (The table below in this article presents The Skilled Investor's Fund Authority Score and other information for the Dodge and Cox Stock Fund (DODGX).
The diversified investment fund strategy of the Dodge and Cox Stock mutual fund (DODGX)
According to its website and its prospectus filing on the U.S. Securities and Exchange Commission EDGAR system, the investment [...])
- Commodity Futures in Your Investment Portfolio (Commodity futures in your investment portfolio - Is there really any future for individual investors?
The Skilled Investor's previous article, "Be wary of the new investment asset classes," voiced skepticism about many supposedly new asset classes. This article delves into the financial science behind this skepticism, as it relates to one of these supposedly new asset [...])
- What is a Well-Diversified Investment Portfolio? (A well-diversified portfolio contains a very large number of individual stocks and/or bonds that are selected without bias toward particular economic segments.
A fully diversified portfolio will approximate the global publicly traded securities markets.
The question about diversification most frequently asked by individual investors is “how many stocks or bonds do I need to be well-diversified?” While [...])
- Fidelity Spartan 500 Index mutual fund (FSMKX) achieves the Best +10 Fund Authority Score (
The Standard & Poors 500 stock index is the most common equity index fund benchmark in the U.S. The S and P 500 tracks about 75% of publicly traded U.S. equity market asset value. The dominant issue in choosing among passively managed index mutual funds and ETF funds benchmarked against the S & P 500 [...])
- American Funds – The Investment Company of America – Class A Shares (AIVSX) net a +3 Fund Authority Score (Fund Authority Scores rate mutual funds and exchange traded funds (ETFs) on the most important economic factors that influence individual investors' net long term diversified investment fund performance. The Skilled Investor developed the Fund Authority Score system to provide individual investors with concise and objective summaries of mutual funds and ETFs for comparisons within investment [...])
- Developing Fund Authority Scores for ETFs and Mutual Funds (
Select mutual funds and ETFs with the most important economic factors that affect long term, diversified, and risk-adjusted investment fund returns
Good things are born small and grow over time. Regularly, The Skilled Investor evaluates individual mutual funds and ETFs and adds new articles that use the Fund Authority Score rating system. To be alerted when [...])
- Use Caution with Classical Investment Books (Use Caution with Classical Investment Books - A Tip from The Skilled Investor
Individual investors should exercise caution when applying the tactics of classical investment books to current markets. The more handcrafted, seat-of-the-pants, and individual actor approach to the securities markets in the pre-computer, pre-networking era has given way to different practices. What might have worked [...])
- The Optimal Investment Strategy for Individual Investors (The Solution - ONLY follow financial strategies that are scientific, passive, diversified, savings focused, risk controlled, low cost, and tax efficient
A previous article, "The Problem - Straight answers about personal financial and investment planning are difficult to find," summarized important reasons why individuals may experience difficulties, even if they are intent upon doing better with [...])
- The Cost of Investment Counselors When You Pay Investment Sales Loads (How expensive is financial advisor compensation paid via sales loads?
A sales load might be the method that you prefer to compensate your broker or advisor. If your advisor is truly competent and ethical, he may be able to manage properly the inherent conflicts of interest that are associated with commissioned investment product sales. Even if [...])
- 10 Personal Financial and Investment Planning Steps in the Right Direction (Increase your knowledge and accelerate your ability to take leadership in the management of your own personal finances and lifetime investing.
This ten-step personal financial planning process will help you optimize the management of your financial planning and investment management affairs over your lifetime, while greatly reducing the unnecessary waste of your money and your time.
- Avoiding Financial Advisor Frauds and Scams – Part 1 (
Part 1 of the The Never-Do List - 22 Good Ways to Avoid Financial Advisor and Investment Counselor Frauds and Scams
This article discusses things that you should “never do” with a financial planner or investment advisor, and it covers adviser selection, contracts, signatures, and ownership title of your assets.
You should never do certain things with [...])
- How Investment Securities Are Valued – Snapshots in Time (
Snapshots in time - How investment securities are valued
Every securities market transaction requires a buyer and seller with differing viewpoints.
Markets can operate, because there are differences between investors in their assessments of the intrinsic value and risk of securities.
Current investment values vary in the eyes of the many beholders of investment market securities. Knowledgeable participants [...])
- American Funds – EuroPacific Growth Fund – Class A Shares (AEPGX) get a +2 Fund Authority Score (The diversified investment fund strategy of American Funds' EuroPacific Growth Fund
According to American Funds' Annual Report for the EuroPacific Growth Fund, the fund "seeks long-term capital appreciation by investing primarily in the securities of companies based in Europe and the Pacific Basin." American Fund's 497 filing on the U.S. Securities and Exchange Commission EDGAR system [...])