The Real Costs of Turnover

The conventional wisdom when it comes to stock investing is that lower turnover is better. Many studies have shown that mutual funds, for example, that buy and sell infrequently tend to outperform those that churn their portfolios. Frequent trading carries with it frictional costs, including trading commissions and the effect of bid/ask spreads. And mutual funds with high portfolio turnover tend to whack their investors with taxes at the end of the year. The same generally holds for individual investors -- the higher the turnover, the poorer the performance.

What is turnover?
The turnover ratio is a statistic often used to measure mutual fund trading activity. According to The Motley Fool's mutual fund glossary, turnover:

Measures how long a fund holds on to the stocks it buys. The longer a mutual fund holds on to a stock and the less trading the fund does, the lower the turnover will be. Since a fund incurs costs every time it buys and sells stocks (just like you do), the lower the turnover, the lower the transaction costs incurred by the fund -- and the lower the capital gains taxes. Ideally, Fools like to see funds that practice the "buy and hold" method of investing -- those funds are the most index-like. Funds that have a turnover of 100% are essentially buying a completely new set of companies every year. Turnover should ideally be substantially lower than the mutual fund average of about 80%. Index funds have turnover as low as 5%.

The costs of turnover
One very influential study on the costs of portfolio turnover was published in The Journal of Finance by two college professors -- Terrance Odean and Brad Barber -- who studied trading records of over 66,000 individual investor accounts from 1991 to 1996. To study the effect of turnover on investment performance, the researchers sorted the investor records into five groups based upon trading frequency.

The article reported that the least active group averaged just 1.44% turnover per year, making them the human equivalents of index funds. To put this into context, if the average investor in this group held 20 stocks, a 1% turnover rate means that one stock is replaced from the portfolio every five years. The highest turnover group averaged 283% annual turnover, meaning that these investors swapped out their entire portfolios almost three times annually. Across all the accounts, the average turnover was 75%. What do you suppose that Odean and Barber found?

Not surprisingly, the most active group trailed the least active group by an average of 5.5% per year. And this doesn't even consider the effect of taxes, which were surely significant. For individual investors and mutual funds alike, the message is clear -- low turnover equals better performance. Or does it?

Is there such a thing as good turnover?
Despite the statistical relationship between high turnover and poor performance, you might be surprised when I tell you that I don't even bother to calculate a turnover ratio for my fund. I don't believe it's a useful statistic for myself or my investors. Let me explain.

One of the problems with the turnover ratio is that it only serves to describe a fund's trading behavior, and it can't be used to make a value judgment. In other words, one can't use the turnover ratio to determine whether the transactions themselves are good or bad. In the absence of any other information, if you asked me to compare one fund with annual turnover of 20% to another with annual turnover of 40%, there's no way I can tell you which fund is better. It very well could be that the fund with the higher turnover will be the better performer.

No question about it, more activity can translate into better results. For example, how many of you rode Cisco (Nasdaq: CSCO  ) or Sun Microsystems (Nasdaq: SUNW  ) or Amazon.com (Nasdaq: AMZN  ) to multi-bagger returns, only to ride them all the way back down again? At some point, the right thing to do would have been to sell and replace the stocks with others whose valuations looked more attractive. Higher turnover in this example would have translated into far better financial results.

Another example of "good turnover" has to do with tax optimization. Because I try to run a tax-efficient fund, I generate some turnover in my efforts late in the year to offset losses with gains, or vice versa, in order to reduce taxes. While this activity materially improves tax-adjusted returns, it also leads to a higher turnover ratio.

My take on turnover
My philosophy on portfolio turnover is simple: avoid unproductive turnover by trying to be disciplined and intelligent about every single investing decision. When you buy a stock, you should know why you're making that investment and what you expect to gain from it. When you sell, you should be doing so for a good reason. In my fund, my partner Matt Richey and I generally look to buy undervalued stocks, and we tend to sell them for one of two reasons -- either the price goes up and the stock is no longer undervalued, or something changes our minds about the quality of the business relative to the stock price. At all times, we try to avoid mistakes of judgment or emotion that can lead to unnecessary and unproductive transactions.

I have personally found that the effort it takes to make informed, rational investment decisions tends to naturally reduce portfolio turnover while also reducing investment mistakes. There's no way you should be replacing every stock in your portfolio on an annual basis if you're making good investment decisions. On the other hand, I don't believe that the kind of inactivity that helped investors in the 1990s will work as well going forward unless they're fanatically disciplined about their stock purchases and willing to hold fully valued stocks for extended periods of time. Bull-market data is better than no data, but I have to wonder how well the super-low turnover accounts in Odean's study performed over the 2000-2002 bear market years.

Finally, if you're a serious do-it-yourself investor, I'd recommend looking at commission costs as a percentage of your portfolio once a year. If you're paying more than 1% of your total portfolio each year in commissions, you should do an honest self-analysis of your buys and sells to ensure you're not developing bad habits and making hasty decisions -- decisions that could lead to unproductive turnover.

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Zeke Ashton has been a long-time contributor to The Motley Fool, and is the managing partner of Centaur Capital Partners, LP, a money-management firm in Dallas, Texas. At the time of publication, Zeke did not own shares of any stock mentioned in this article. Please send your feedback to zashton@centaurcapital.com.


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