How Portfolio Turnover Affects Mutual Fund Return

I just finished reading John Bogle’s Common Sense on Mutual Funds. (As much as I love reading about investing, it’s been a bit of a slow process, interrupted by the reading of several other books.) One thing that the book has gotten me thinking about is turnover and how it affects return.

Turnover within a Fund’s Portfolio

Two statistics courtesy of Morningstar’s handy Fund Screener tool:

• Average annual portfolio turnover within domestic stock funds: 95%.
• Average annual portfolio turnover within international stock funds: 80%.

Yikes! That means that, on average, mutual funds hold a stock for between 12 and 15 months before selling it. That’s not exactly indicative of a buy-and-hold philosophy.

That scares me. I’m pretty firmly convinced that over a period of roughly one year, the stock market is highly unpredictable (and individual stocks are even more unpredictable). And yet, with turnover ratios approaching 100%, most fund managers are betting precisely on their ability to predict what a given stock will do over the next year. I’m skeptical as to the probability of success in such an endeavor.

However, for the sake of argument, let’s take a leap of faith and assume that these are professionals, and they do have some ability to successfully make such predictions. Even in such a scenario, there’s still good reason to look for funds with lower turnover. That reason, quite simply, is cost.

Higher turnover results in higher costs. Of course, there are the obvious transaction costs. (It’s not free to buy or sell a stock.) But there are other, less obvious costs as well.

For instance, if a fund wanted to sell all of its shares of a given stock, it’s likely (especially if it’s a particularly large fund) that such a large liquidation will move the price of the shares slightly downward. As such, the fund is likely to receive a lower price for the last shares liquidated than it received for the first shares liquidated. Let’s say that this hidden cost amounts to a 0.5% loss of value. (Bogle actually cites a figure of 0.8% provided by Investment Technology Group, but I’m trying to be conservative here.)

Then, in most cases, the fund will choose to invest the cash in another security. In this case, the opposite will occur: Purchasing a very large amount of a given stock will cause the share price to move upward, however slightly. This again results in a hidden cost. Again, let’s assume that the cost is a 0.5% loss of value.

In all, this results in a 1% loss of value for the portion of the portfolio that was liquidated and reinvested. With the fund industry’s average annual turnover of 92%, this is going to result in an annual hidden transaction cost totalling 0.92% of assets.

0.92% may not seem like a huge deal, but with a long-term market return of approximately 9%, it means that hidden transaction costs could consume fully one-tenth of that return. (If we chose to look at after-inflation return, it would be consuming approximately one-sixth of the return!)

Also noteworthy is the fact that these transaction costs are entirely unreported to investors. In fact, it’s quite possible that they’re not tracked at all by most fund managers.

The two takeaways I’ve found from this analysis are as follows:

• Obviously: Look for funds with low annual turnover.
• Less obviously: The cost advantage typically attributed to larger funds (due to overhead being spread out over a greater number of invested dollars) is–to an extent–counteracted by these hidden transaction costs, as the upward or downward pressure on share price is necessarily going to be greater as the amount of shares purchased/liquidated increases.

And what if you have a taxable account?

The costs associated with portfolio turnover only become worse if you own the fund in a taxable account.

If you (or a fund) own a stock for several years without selling it it, you’re deferring taxation on the appreciation in value. This is akin to an interest-free loan from the Federal government. If you–or a fund you own–regularly sell securities after holding them for short periods, you’re passing up on your ability to defer this taxation.

Furthermore, if you were to own a share of something all the way until your death, your heir(s) receive a stepped-up basis. That is, their cost-basis is equal to the market value on the day they inherit it, thereby meaning that all of the appreciation that occurred during your lifetime would go entirely untaxed. High turnover within a portfolio eliminates this possibility.

Lastly, high turnover means that most gains are short-term capital gains, which are taxed at higher rates than long-term capital gains. (For now, anyway. There’s no saying for sure how this will change in the future.)

Overall Lesson

This sure makes a buy-and-hold portfolio consisting of funds that themselves exercise a buy-and-hold strategy look good. 🙂