Mutual Funds: Costs

Turnover and Cash Reserves

Mutual Funds

By Bill Barker

Okay. So we've covered the first and largest aspect of why actively managed mutual funds underperform the market's returns and the returns of index funds -- the perniciously high expense ratio. As noted elsewhere, there are two other major reasons why mutual funds underperform the market: turnover and cash balance.

To every fund, there is turnover, turnover, turnover. And knowing the historical turnover of your fund choice is a necessary step to understanding the likely performance of a fund over time.

A fund's turnover rate basically represents the percentage of a fund's holdings that change every year. "Turnover" is the gross proceeds from all sales divided by the total assets in the mutual fund. In plainer English, turnover represents how much of a mutual fund's holdings are changed over the course of a year through buying and selling.

Managed mutual funds have an average turnover rate of approximately 85%, meaning that funds are turning over nearly all of their holdings every year. Many funds, in fact, have turnover ratios of more than 100%, meaning their average holding period for a stock is less than one year.

Because buying and selling stocks costs money through commissions and spreads, a high turnover indicates higher costs (and lower shareholder returns) for the fund. In short, as Dale Wettlaufer (TMF Ralegh) wrote in one of his Boring Portfolio reports: Turnover Kills.

A mutual fund is merely a collection of stocks, and it is at this point widely agreed that a "buy and hold" strategy is the one that has the highest probability of rewarding an individual. Given that fact, it is confusing, to say the least, that the professional money managers who are employed to guide mutual funds so completely ignore what is probably the first tenet of sound investing. On top of the hit to returns that frequent trading exacts through commissions and spreads, funds that have large turnover ratios will end up distributing yearly capital gains to their shareholders. Shareholders will have to pay taxes, and paying these taxes significantly reduces returns.

Keep a close eye on the turnover rate of any fund you own, and if you want to or have to own mutual funds, look to own funds with lower-than-average turnover rates -- preferably no higher than 50% and hopefully much lower. For comparison, index fund turnover can be around 5% or lower.

The other principal category of actively managed mutual fund behavior that hurts shareholders is the cash reserves that make up such a large percentage of so many mutual funds. For various reasons, actively managed mutual funds don't invest all the money at their disposal, but instead maintain cash balances of approximately 8%.

Whoa. What's up with that? The annual rate of return on cash over the last 120 years or so has been about 4%. The average annual return on stocks is around 11%. Mutual fund managers are charging their shareholders an average of 1.5% a year on that 8% that they are keeping in cash. That's cash that can't appreciate at the rate that stocks appreciate. Hey, you're putting your money into mutual funds to own shares of stocks, not to pay somebody to own cash for you.

There are essentially two reasons for this cash reserve maintenance. First, mutual fund managers are keeping money on hand in case shareholders decide to sell their shares suddenly. If there is a market crash, or enough of the Wise show up on television to proclaim that "The end is nigh," there might be massive redemptions by shareholders. To be prepared for this type of calamity, actively managed mutual funds leave a lot of money available so that they aren't forced to sell off large chunks of holdings right at the time the market is offering the lowest sales prices.

While this might sound like it makes some sense -- after all, you probably don't and shouldn't keep every penny in stocks every day with no cash to write checks -- this high degree of caution ends up being a very large opportunity cost. Keeping 8% of assets in cash all the time simply can't produce the returns that keeping that 8% in stocks would.

Additionally, mutual fund managers apparently keep some money in cash under the belief that doing so will provide them with flexibility for those occasions when there is a fire sale in the market. This is the "buy low, sell high" theory -- managers apparently believe that they can time the market, sell off some of their holdings when the market is "too high," and buy back some shares when there is a better price available. While this is all very well in theory, in practice things have worked out just the opposite. Studies show that mutual fund cash reserves are at their lowest levels at market highs, and at their highest levels at market lows. In short, if there is anyone who does know how to time the market (doubtful), it is definitely not mutual fund managers.

Speaking of things that mutual fund managers don't seem to know how to do, let's talk about keeping taxes under control.

Next: Taxes »