Recently, a new client asked one of our advisors how high portfolio turnover would effect their portfolio. This timely question makes sense; after all, we often warn our clients and other investors about the disadvantages and high costs of wealth management strategies based on active management.
Our answer? High portfolio turnover is the source of most of the extra costs associated with active management – costs that are completely unnecessary and avoidable with more efficient investment guidance. Read on to find out why.
Financial Strategies and the True Costs of High Portfolio Turnover
First, some definitions: A 100% turnover rate means that over the course of a year, virtually all of the stocks in a portfolio are sold and replaced by other stocks. In contrast, a 20% turnover equals an average holding period of five years.
During the 1990s, the average annual portfolio turnover of actively managed, large growth funds was 97%; in the 2000s, this exploded up to 162%, according to Morningstar. As of 2013, actively managed mutual funds have an overall turnover rate of 85%.
So why is turnover such a bad thing? Because high portfolio turnover generates major additional costs because it requires managers to exert more effort - and no one works for free. Making matters worse, these costs represent dead weight. They offer no added value because as a general strategy, portfolio turnover does not improve overall average performance. After all, the mutual fund managers are buying from and selling to each other – they’re simply passing product around. One manager’s gains are another’s losses, and vice versa.
Game theory would call this a zero-sum game, but in reality, it’s a negative-sum game because turnover leads to:
More transaction costs
Higher tax burden
Why Does So Much Investment Guidance Include Active Management Strategies?
Multiple studies (from Sharp in 1991 to Elton in 1993 to French in 2008) indicate that portfolio turnover diminishes a fund’s net return. In fact, studies find a perfect inverse relationship between turnover and performance – and high turnover is robustly associated with poor performance.
Plus, there’s an elephant hiding in this room: High portfolio turnover rates are necessary in order to justify an active manager’s existence. A buy-and-hold strategy would likely lead a board to question why the manager was actually needed, a fact that underlies high turnover’s counterproductive, self-serving nature.
Comparing Costs: Active Management vs Passive Management Investment Guidance
Vanguard’s John Bogle describes transaction-related costs as the “invisible cost” of money management. These costs stem from sales commissions and differences in the bid and the ask prices inherent in the market. Those costs are estimated to be approximately 1% for each 100% of portfolio turnover.
But wait, there’s more! Portfolio turnover also creates the additional burden known as market impact costs. When a mutual fund buys or sells a block of stock, this transaction causes the stock to move beyond its current bid or ask price, thus increasing the cost of trading. In other words, market impact increases the cost of buying which decreases the proceeds from selling, making every roundtrip just that much more expensive – and higher turnover means more roundtrips. Conservative estimates estimate that market impact adds another 1% (at least) to the costs active managers must beat to achieve above-market returns. Might not sound like much, but it’s cumulative – and high turnover means costs add up fast.
Oh, and the potential for market impact costs is (just) one of the reasons mutual fund managers give for not fully and promptly disclosing their strategies and activities. In fact, the SEC doesn’t even require reporting of these costs.
Now add in the average expense ratio of 1.5% and the costs of active management come into focus. By contrast, the total costs of a passively managed fund average about 0.5% and often even less. Premier Financial Group's portfolio cost, for example, is a maximum of .44% for the internal fund cost.
Choosing among alternatives should involve a comparison of costs and benefits. If the costs are impossible to identify, how can investors make effective, well-informed decisions?