Import of Turnover Increase Is Debated
May 15, 2000
With the current yo-yo equity market, it should not be surprising that turnover rates in mutual fund portfolios have been high. But opinions differ as to the impact on investors.
"To listen to the pontifications of some market experts,' turnover is the culprit for a host of problems, from the stock market's gut-wrenching volatility to tax-inefficient portfolio management to investment under-performance," according to Turner Investment Partners of Berwyn, Pa., in a position paper released earlier this year.
"We wouldn't be entirely surprised to find they are blaming turnover for El Nino and the greenhouse effect as well."
"In our view, turnover is being unfairly maligned," the firm said in the paper, "Turnover is Good." "Perhaps part of turnover's image problem, the conception that turnover is bad, is the association of heavy trading with churning' - the distinctly client-unfriendly practice of brokers continually buying and selling shares to generate fat commissions.
"But heavy trading has a positive aspect as well: it can help capitialize on market volatility to enhance a portfolio's returns. Research and our own experience have shown that turnover can in fact maximize equity returns, especially for growth stocks and in periods of heightened stock-market volatility like the present."
Nevertheless, current market volatility does not explain why turnover has been steadily increasing over the last six years. Portfolio turnover has risen steadily from 1994, when it averaged 76 percent, to 1999, when it averaged 92 percent, according to Bloomberg News.
That average remained about the same through May 2 of this year, according to Morningstar, a financial services information company in Chicago. It did not have numbers for earlier periods immediately available.
There has been marked variations in portfolio turnover from Morningstar category to category (see chart), according to the year-to-date data. Turnover was more than 100 percent in large growth (103 percent), mid growth (140), small growth (117), health (108), natural resource (122), technology (116), Pacific/Asia (108), emerging markets (102) and precious metals (109) funds. In contrast, it was less than 70 percent in large value (67), large blend (67), small value (65), financial (57), real estate (59) and utilities (55) funds.
At least one study calls into question Turner's contention that portfolio turnover can maximize investment returns in the long term. When it examined the relationship between turnover and performance during the years 1992 to 1997, Financial Research Corporation of Boston found that there is "no conclusive evidence to suggest that portfolio turnover impacts investment performance."
That study did find, however, that low turnover funds outperformed high-turnover funds in 1996 and 1997. But, it concluded this is most likely a "residual of unusually high volatility in a steadily rising equity market."
Although the FRC study explored the relationship between performance and turnover, it did not take into account the tax consequences of turnover and how that may impact performance. Critics of turnover claim the practice increases an investor's tax liability.
That may not be the problem it used to be, though, according to Geoffrey H. Bobroff, a principal of Bobroff Consulting in East Greenwich, R.I.
"That thinking puzzles me because much of the industry's assets are tax deferred," he said. "More than 60 percent of all mutual fund assets are in some kind of qualified retirement program or tax-deferred program, so the net after-tax impact of a fund's management is irrelevant to those investors."
"If I'm one of those investors, I want my manager to roll the dice," he said.
Ed Rosenbaum, director of research for Lipper in Summit, N.J., said attempts to make relationships between turnover rates, performance and tax liability are overly simplistic.
"There are a bunch of different ways to get high turnover numbers just as there are a bunch of different ways to get low turnover numbers," he said. "Low turnover numbers in a portfolio of bad stocks is not a good thing. It could indicate a reluctance to sell stocks that ought to be sold. On the other hand, high turnover doesn't necessarily mean a high tax burden because every stock you sell, you don't sell at a gain."
When stocks do sell at a gain, however, turnover can have a significant impact on an investor's earnings, said John Siciliano, managing principal of the Payden & Rygel European Aggressive Growth Fund in Los Angeles. His fund gained 64.18 percent in 1999 with no turnover in stock, he said. A fund with comparable gains, but with 50 percent of those gains obtained through turnover of stock, would net an investor 5.5 percent less than his fund, he said.
Faced with the current level of volatility in the markets, managers do not have much choice about turnover if they want to maintain their fund's performance, Bobroff said.
"For example, if you held on to your Microsoft, rather than selling it, you'd be facing a substantial loss," he said.
High portfolio turnover may be inevitable in today's market, he said.