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.”
Tags: investment portfolio
Personal Financial Planning
- Pay Lower Expenses To Get Higher Investment Returns – Part 2 (
Pay lower investment expenses to get higher investment returns
While financial services industry sales people tell you that you need to pay more to get more, the correct answer is the opposite.
Excessive investment costs are a plague on your personal financial planning. Excessive investment expenses are one of the most significant barriers to lifelong family financial [...])
- Your Valuable Assets Are Simply Your Evolving Estate (
Your investment portfolio and other property assets are simply your evolving estate
A previous financial article, “The Solution - ONLY follow financial strategies that are scientific, passive, diversified, savings focused, risk controlled, low cost, and tax efficient,” suggested that investors are much better off with a well-considered financial plan. A stable set of financial beliefs can [...])
- Diversify To Avoid Investment Fraud (Another kind of investment diversification that individual investors should consider important relates to the failure or corruption of the financial industry intermediaries and fiduciaries that hold individual investors’ securities.
This meaning of diversification has nothing to do with scientific investment principles related to optimal portfolio diversification. However, it is still very important. Prudent investment practices would [...])
- 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 [...])
- The Most Important Determinants of Your Lifetime Wealth (
Your personal earnings, expenditures, and savings are the most important determinants of your family’s long-term financial wealth
Summary: How much you earn, spend, and save are by far the most dominant determinants of your long-term financial well-being. Self-control in your decision-making regarding consumption is far more important than clever investing. Expenditure control works, while attempts [...])
- Be Wary of New Investment Asset Classes (
Hear ye, Hear Ye, individual investors: Be wary of new investment asset classes - A Tip from The Skilled Investor
Many promoters in the financial services industry have shown a strong proclivity in recent years to invent and to market supposedly "new" investment asset classes. Industry advocates will claim that these new asset classes deserve some [...])
- Part 2 of the Biggest Personal Finance Story of the Past 30 Years (< -- Go to Part 1
The Biggest Personal Finance Story of the Past 30 Years - Part 2
To understand what has happened to the market valuation of the financial services sector, particularly over the last 30 years, you should view Figure 4 on page 16 of the financial study by Jeremy Siegel and Jeremy Schwartz [...])
- The Kind of Financial Advisor You Need (
The kind of financial advisor you need - A Tip from The Skilled Investor
Good or bad, financial advisors are expensive. If you need a financial advisor's help and you carefully select a good financial advisor, the value of the personal finance and investment advice that you receive might easily repay the advisor cost. However, bad [...])
- 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 [...])
- Objective Personal Finance Answers Are Hard to Find (The Problem - Straight answers about personal financial planning and investment management are difficult to find
In this article, The Skilled Investor summarizes some of the significant problems faced by ordinary individuals, when they attempt to plan their family finances. This is the first in a series of articles that will provide scientifically grounded decision rules [...])
- 15 Value-Added Individual Investor Activities (Before estimating the investment value that you might add or take away from your portfolio, you first need to determine whether your strategies are or are not likely to lead to optimal risk-adjusted investment returns.
This value estimation is separate from any hourly opportunity cost related to spending time on your investments versus an alternative use [...])
- Own Investment Mutual Funds and ETFs – Not Individual Securities (Own Investment Mutual Funds and ETFs - Not Individual Securities
Owning individual stock and bond securities is just a big waste of your valuable time and money
Individual investors tend to be terrible investment portfolio managers. Almost everyone can hire an index fund manager to do a much better job for far less time, money, risk, and [...])
- Understand the Confusing Securities Market Motion Picture (
Securities markets are usually very quick to adjust prices to reflect new information. However, this price adjustment process may take longer and be more volatile, if the new information is ambiguous.
At any point in time, market participants will already have used more or less rigorous valuation methods to judge their expected risk-adjusted value of securities. [...])
- The Quality and Cost of Advice Paid by Investment Sales Loads (Can you really get free and objective investment advice, when you pay investment sales loads?
Excessive investment expenses are one of the most significant barriers to your family's lifelong financial security.
Excessive investment costs are a plague on your personal financial planning. While financial services industry sales people tell you that you need to pay more to [...])
- The Quality and Cost of Advice Paid by Investment Sales Loads – Part 2 (
Can you really get free and objective investment advice, when you pay investment sales loads? (Part 2 of 2)
Excessive investment costs and investment expenses are a plague on your lifetime personal financial planning.
Excessive investment expenses are one of the most significant barriers to lifelong family financial security. While financial services industry sales people tell you [...])