Portfolio Turnover

When funds trade frequently, costs go up. Is this to your benefit?

What is it?

All pooled investments buy and sell some portion of their holdings every year. The rate at which they do so is called the 'turnover' of their portfolio.

• If every share is sold and replaced on average every year the turnover is 100%.
• If every share is sold and replaced on average every two years the turnover is 50%.
• If every share is sold and replaced on average every six months the turnover is 200%.

Why do we care?

One of the themes of this website is the hidden cost of investing through managed or structured products. One cost that is more hidden than most is the direct cost of buying and selling shares within funds.

Fitzrovia International used to provide free detailed cost information on UK funds. Now absorbed into the Lipper brand under the Thomson Reuters umbrella, its reports now cost money. However a few years ago it revealed that the average turnover across all UK funds was about 50%. Some funds had turnovers above 300%.

A government-sponsored report calculated that it costs an institutional investor 1.7% to sell one share and buy another. So the average fund needs to turn this activity into an extra 0.85% per annum to beat a dart thrower. A fund with a 300% turnover is backing its skill to the extent of a whacking extra return of 5.1% per year.

Do the results justify the trading?

Well, Alistair Blair in the Investors Chronicle plotted turnover against return for the funds specialising in North America. There was a statistically significant negative correlation (returns went down as portfolio turnover went up). Which should surprise nobody.

A famous study in the US examined investors brokerage accounts in the period 1991-96. The 20% least active accounts had a portfolio turnover of 1% and made a return of 17.5% per annum. The most active 20% had average annual turnover of more than 100% and annual returns of 10%.

When stockbrokers over-trade a private client's discretionary portfolio to generate brokerage income it is called "churning". This scam is rightly illegal.

OEICs may give their business to brokers within the same corporate group at undisclosed rates and/or in return for soft commissions (see Costs Unwrapped). We are sure that no churning occurs. What do you think?