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How Turnover in Your Portfolio Affects Performance

I frequently mention that, when selecting mutual funds, it’s generally advantageous to look for funds with low turnover.

What I’ve noticed from comments on the blog and emails I’ve received is that some investors seem to miss the fact that the same thing applies to our own portfolios. Generally speaking, increased turnover is a bad thing.

Increased Costs

Most obviously, increased turnover leads to increased transaction costs:

  • If you purchase individual stocks or bonds, each transaction comes with a cost. Even if you’re using a discount brokerage firm, those $7 trades begin to add up.
  • If you jump between funds, there may be a transaction cost (depending upon which funds you use and how quickly you sell them after buying them).
  • If you’re investing in a taxable account, turnover means incurring capital gains taxes earlier, which is harmful to returns.

Increased Risk

Less obviously, increased turnover in your portfolio creates a cost in terms of extra risk you take on.

For example, there’s a high probability that if you hold a stock-based mutual fund for a long enough period of time, you’ll enjoy a positive rate of return. However, if you constantly jump back and forth between various mutual funds, it’s no longer such a sure thing.

Increased risk and increased costs, without an increase in expected return. What’s not to love?

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Comments

  1. High turnover increases taxes as well. If a portfolio turns over its holdings once every ten years, then the investor only has to pay 15% long-term capital gain tax once every ten years on average. If a portfolio turns over its holdings once very six month, as many funds and investors do, the investor has to pay the 30% short-term capital gain tax every year. It’s clear which is better.

    Of course one could argue that high turnover might indicate better trading skills and as the result better investment returns. Except the evidence is to the contrary. Berkley professor Terry Odean has a research paper “Trading is hazardous to your wealth?” that shows the higher the account turnover, the lower the account returns.

    Michael Zhuang
    http://www.investment-fiduciary.com

  2. “there’s a high probability that if you hold a stock-based mutual fund for a long enough period of time, you’ll enjoy a positive rate of return. However, if you constantly jump back and forth between various mutual funds, it’s no longer such a sure thing.”

    If there are zero transaction costs, then I disagree. Holding one fund for a long time has just as much of a random outcome as owning a bunch of funds for a very short time each. What’s the difference?

  3. Dave C. says:

    I’ll bite – there is no such thing as zero transaction cost?

    Mark, I’m going to assume that every transaction you make in stocks or funds carries a transaction cost. Whether we pay directly, or indirectly, some broker somewhere is going to get paid for putting a buy order in, right?

  4. Costs are one of the most important factors when investing in a fund and when enjoying investment success. A high turnover increases the cost for the assets under management. Therefore, such funds should be avoided. A high turnover is also an indication that the manager tries to time the market – or entries and exits of stock investments – frequently. Studies have shown that timing the market does not work for most investors.

  5. Fresno Money Coach says:

    An alternative to consider would be ETF’s (Exchange Traded Funds). They have both lower turnover costs and lower management costs when compared to Mutual Funds. On the “down” side, they are passively managed (as opposed to mutual funds, which are actively managed – hence the turnover). I put “down” in quotes because I don’t really consider that to be a negative feature, but some do. You can find an ETF to match just about any Index or Asset Category you could want. However, as always, make sure you do your homework before investing…

  6. Fresno Money Coach says:

    @Mark,
    Many studies have shown that the majority of investors’ portfolios’ underperform the market. (I’ll try to find a link to one for you) The key reason for this is emotion. That is a strong argument against jumping from fund to fund – as many investors do. Even with a theoretical “zero transaction cost” history shows that sticking to your plan will outperform frequent changes a vast majority of the time.

  7. I apparently was not clear, so I’ll try to correct for that.

    Fresno: No need for a link. I am well aware of the studies that show that the more an investor trades, then less well his/her performance.

    I also recommend against jumping from fund to fund m- when fees are involved.

    Dave C: Yes, there’s a cost to trade.

    The point I was making is that I disagree with this:

    “For example, there’s a high probability that if you hold a stock-based mutual fund for a long enough period of time, you’ll enjoy a positive rate of return. However, if you constantly jump back and forth between various mutual funds, it’s no longer such a sure thing.”

    My thoughts: There is no reason to believe that holding one fund for a long time is any better than switching funds often. There is no reason to believe that it will ‘eventually’ provide a positive return – especially when compared with holding different funds.

    If you trade no-load funds and if you deal directly with the funds – or at least a broker who charges no fees for such transactions (I never trade funds and have no idea if any such brokers exist) – that means theoretically, zero transaction costs. That is the situation to which I am referring. Any one fund for a long time is NOT better than a new fund every week – as long as there are no costs involved in switching.

    If my premise is incorrect – if you cannot wire funds to Fund B at the same time that you close out Fund A (and have them wire funds to you – again at no cost) – then my comments don’t hold water.

    Again, my point is that – assuming no cost – it’s ok to change funds because the results of any fund are random. One fund is as likely to outperform as another.

    I apologize for any confusion.

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