On Mutual Fund Turnover

I’ve been making some changes to the Tarpon Folio lately, which has got me thinking once again about turnover, or how much of a fund’s holdings change every year.

Turnover in Tarpon has averaged 58% a year. That turnover is considerably higher than I’d like, all things being equal. In contrast, the Gecko Folio has averaged turnover of closer to 20% per year. Nonetheless, I am okay with the turnover in Tarpon to date – for three reasons, really.

The first is that, thanks to window trades at our custodian FOLIO, we don’t pay a dime in commissions. Zero, zilch, bupkus. So the trading I’m doing is not eating away at our returns at all due to commissions.

Also thanks to FOLIO, I have pretty granular control over the tax lots of the shares my investors and I own. This topic is worth a few posts all on its own, but those will have to wait. For now, my point is that I am buying and selling in as tax-efficient a way as possible. So the amount of our returns that is getting eaten up by the IRS is as small as possible.

The third reason I’m okay with it is because that turnover is really the result of a high-class problem: Tarpon doubled in value in its first thirteen months. I try hard to buy shares in good companies when they’re cheap, and I sell them when they reach what I think they’re worth. Full stop. So I view that turnover in Tarpon as a reflection of the valuations of the companies we own, or more specifically, the gaps between value and price closing pretty quickly to date. That said, try as I might, I don’t anticipate those gaps narrowing as quickly in the future as they have the past three years, so our turnover should be less from here on out. In any case, I think it’s important to differentiate between turnover that is a consequence of a disciplined selling process, as opposed to trading just to trade. Like, say, mutual funds seem to do.

Estimates on the average mutual fund turnover vary. Here is a slide I used at my annual meeting a few weeks back that referenced some studies that indicated average mutual fund turnover was 89% a year. (Also note the impact of high turnover on returns.)

As mentioned here, though, there is another analyst at Morningstar who believes the average turnover ratio for actively managed domestic stock mutual funds is 130% a year. And since we know the vast majority of mutual funds fail to outperform the market, I think it’s safe to say that they’re not selling because the shares they own have gone up a lot.

So as much as I gnash my teeth about buying and selling, I can’t help but see those consistently high turnover numbers and ask:

Is that really investing, or is that gambling?

I believe actively managed mutual funds have crazy-high turnover because they are chasing returns, pure and simple. They are trying to hop on the latest hot tip, or trying to juice just a little bit of return out of a stock by riding momentum upward. Or something else. Frankly, I have a hard time explaining exactly what those guys are trying to do most days.

Getting more return isn’t a bad thing, of course, but there are big hidden costs to all this activity for mutual fund investors.

The first cost is indirect but important – research. Ever wonder why high-turnover growth funds that hold 150 stocks have higher expense ratios than low-turnover value funds that own shares in just 20 companies? One reason is that it costs a ton to analyze all of those stocks. A mutual fund has to hire or assign a small army of researchers to sift through all the companies that they invest in. And if every share that a mutual fund buys in January has been sold out of the portfolio by December, that means those research costs are through the roof. Investors are effectively paying for that through higher fund fees.

The opportunity costs here are also huge. While that manager is chasing short-term returns, perhaps trying to earn a quarterly bonus, he’s passing up on genuine investment opportunities that may pay massive returns to a more far-sighted investor. For a manager replacing all of his portfolio each year, the best investment doesn’t get his attention – the flashiest investment does.

The other relevant direct costs are commissions and taxes. Every trade related to that 130% turnover costs you money in commissions you pay (surprise!) and results in a taxable transaction of some sort. While far too few of those trades end up leading to a capital gain, many of them still do. And all that churning ain’t happening with an eye on what’s best for your taxes, folks.

My point is that it’s not what you make on the funds you’re invested in – it’s what you keep. And if you’re invested in mutual funds, then the odds are good that you’re keeping less than you think.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
This entry was posted in For Investors. Bookmark the permalink.

One Response to On Mutual Fund Turnover

  1. Kirk Kinder says:

    Great post, Cale. You are so right about commissions being an enormous downside of mutual funds. Every mutual fund investor needs to review the Statement of Additional Information to see the true costs of the fund. That is where the commissions are hidden. It is sometimes another percentage point in annual expenses.