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Some Mutual Funds Thrive on High Turnover

The fund industry scandal has cast market timing, and frequent trading as bad news for mutual fund investors. But when the "timers" are actually fund portfolio managers whose dizzying spinning in and out of securities is eagerly embraced as a part of their core investment strategy, is the news still bad for investors, or is outperformance the result?

While retail fund investors may be discouraged, penalized or even banished from flipping in and out of funds to time the market, there is a small faction of fund managers who feast on a steady diet of turnovers. These opportunists continually seek thrills and deals by skipping in and out of both equity and fixed-income securities.

While these bets don't always pay off, even small rewards can quickly add up to large gains. On the flip side, however, they also elevate the fund's trading costs, and push the fund's annual turnover ratio to staggering levels.

Of course, high turnover isn't inherently bad. "High portfolio turnover, in and of itself, does not necessarily constitute a bad investment," said Jeff Keil, vice president of Global Fiduciary Review at Lipper. "The bottom line is that it is a tradeoff between cost and performance."

The actual formula used to calculate a particular fund's turnover ratio is: the lesser of purchases or sales, divided by the average of the month-end total net assets of the fund, measured over the particular period, Keil explained. The "lesser" figure is used so as not to skew the figures for funds which are seeing a tsunami of inflowing cash, he added.

Turnover: Up, Up and Away

A turnover ratio of 100%, for example, usually means that every single portfolio holding has been changed within the year. A 200% turnover ratio indicates that the whole fund portfolio was turned over every six months, etc.

How high can those turnover ratios soar? While the sky is the limit depending on just how fervent securities trading is, it is not unheard of for turnover rates to zoom past 500% and even push well past 1,000%. According to Morningstar, almost 100 mutual funds currently possess turnover ratios in excess of 500%. Sixteen funds own the bragging rights to turnover higher than 1,000% (see accompanying chart).

Focused funds, which hold fewer securities, logically tend to have higher turnover ratios, according to Morningstar.

So, which fund is the turnover king? The Rock Canyon Top Flight Fund, with its staggering 3,111% turnover ratio, leads the pack. This nimble $19 million no-load fund began operations at the start of 2003, and ended that year with a 52.8% return, pushing the fund's performance beyond that of 94% of its small-blend peers.

But while the fund is still a fledgling, its behind-the-scenes investment philosophy which centers on frequently jumping into new opportunities according to ever-changing proprietary quantitative portfolio models, isn't new.

The fund is run by Jonathan Ferrell, the president of Rock Canyon Advisory Group of Provo, Utah. Ferrell founded his firm in 2002, after leaving Provo neighbor Paragon Capital Management, where he had been a director. Paragon originally adopted the current quick- trading investment philosophy in 1999, and today runs a similarly invested separate portfolio, the Paragon Top Flight Portfolio, which has 50% of its assets currently invested in Ferrell's mutual fund. The remaining 50% is invested across several other mutual funds.

Buy & Hold vs. Flip & Go

"Our whole philosophy was built around rapid trading," said Dave Young, founder and president of Paragon Capital, which uses a tactical allocation approach. Although most mutual funds preach the buy-and-hold philosophy, some savvy managers have found that they can add a lot of value by embracing a rapid trading style, he said. History has shown that the investment styles that are winning are always changing, Young said, proving it is impossible to predict what sectors, asset classes or styles will be working the best at any point in the future.

Although investment pundits usually use that unpredictability to make the case for diversifying across 15 investment classes, then waiting for at least one sector to outperform, Young doesn't agree. "Why would you want to own losing investments?" he asked rhetorically. "They should focus on which styles they should be in," he added. That allows fund managers to capture the best possible return in any market, and avoid securities that are falling, he maintained.

The Rock Canyon Top Flight Fund invests in common stocks and ETFs, and rotates between sectors (technology, retail, etc.) as well as asset classes (large-, mid- and small-cap) and styles (growth and value). The fund holds both long positions and invests in intra-day short positions used as hedging tools against market swings. Those hedges tend to drive that turnover ratio to extremes, Young noted.