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.”
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