How Important Is Turnover?

Last year I examined the predictive power of a number of data points, but I didn't test turnover. Because many investors use it in their selection process, I thought I'd put turnover through the paces to see where it shakes out versus the other data points.

I'll walk you through what turnover means, how I tested it, what the tests show, and finally, what turnover tells you about a fund's strategy.

An Old Formula
The SEC mandates how fund companies calculate turnover, and that method could stand to be updated. The algorithm is a sum of the dollar value of the lesser of purchases and sales during the fiscal year divided by average net assets over that period. As you'd expect, a 100% turnover ratio means the manager has turned over an amount of shares equal to the total value of the portfolio. It doesn't actually mean he's held nothing for more than one year--he may have held half the portfolio unchanged throughout the year and turned over the other half twice.

The SEC uses purchases or sales rather than both because that would be double-counting. However, by choosing the lesser of the two rather than summing them and dividing by 2, the SEC is allowing some quirky results to sneak in. If a fund has had large inflows or outflows in a year, the managers may have made far more purchases than sales or vice versa. In that case, the turnover rate would be significantly understated.

Bond funds present an additional challenge. A maturing bond constitutes a sale, so a short-term bond fund where most of the holdings are maturing in a year will run near 100% turnover simply by buying an equal amount of bonds to replace the ones that mature.

How We Ran Our Test
Using rolling five-year periods beginning in 2000, we ran a test that was similar to past tests of predictive value. We calculated returns and success rate to find out what the chances are that a fund would survive and outperform its peers over the ensuing period. So, a 40% success rate over a five-year period tells you that 40% of the funds in a certain group survived and outperformed. If another group had a 20% rate, you know the former was better than the latter.

The idea is to use real data that existed in the past and see how one might have done using that past data rather than using today's data and projecting backward. Also, asking whether a fund survived is a way of accounting for the fact that many weak-performing funds are killed off each year in a way that can skew studies of fund data.

For turnover, I added another wrinkle. I looked at pre-expense returns. I wanted to separate turnover from expenses. The lowest-cost funds are mostly index funds, and those funds generally have low turnover. Were we to run the data including expenses, we might find noisy results in which low turnover simply captured low costs in the form of index funds.

What We Found
Overall, turnover proved to have a smidgen of predictive power, but it was not as strong or consistent as the best predictors. While fees, stars, and manager tenure produced a nice stair-step down, the turnover results were lumpier. So while the cheapest quintile beats the next-cheapest quintile and so on, turnover didn't work that way.

Instead, we had rather flat results up until the highest-turnover quintile, where results really plummeted. So, put turnover behind stars, expenses, and manager returns, but put it ahead of active share. Along asset-class lines, turnover had some predictive power for equity funds. Shopping for low-turnover balanced funds would have actually hurt performance, and turnover had no effect--positive or negative--in bond funds. No big surprise there.

The results are pretty close to what other studies have found. For example, Roger Edelen, Richard Evans, and Greg Kadlec found a small impact for turnover in their paper, "Scale Effects in Mutual Fund Performance: The Role of Trading Costs." However, in their study it wasn't as powerful as expense ratios or their estimate of trading costs.

Success Rates
Here we are using the success rate I defined above: the chances a fund survives and outperforms.

The success ratio for the lowest-turnover quintile of U.S.-stock funds did only a tiny bit better than the middle quintile or average for the category: 38% of the lowest-turnover quintile succeeded, while 38% of the second-lowest-turnover quintile succeeded, followed by 37% for the middle quintile and 36% for the fourth quartile. But when we get to the highest-turnover quintile, the success rate falls to 31%. Thus, the data suggest you are a little better off steering clear of large funds in the highest quintile of turnover for their category as they are most likely to have high trading costs. The table below shows what that quintile is for each category.

For foreign equities, turnover had a little more power. the lowest-turnover quintile had a success rate of 43% versus 36% for the middle quintile or average level and 29% for the highest-turnover quintile.

Turnover didn't help at all with balanced funds and taxable-bond funds. Among balanced funds, the lowest-turnover quintile produced a meager 36% success rate versus 40% for the middle quintile and 37% for the highest-turnover quintile. For taxable-bond funds, the figures were 46% for the lowest-turnover quintile, 40% for the middle quintile, and 46% for the highest-turnover quintile.

Thus, you have a small level of predictive power for turnover at equity funds.

Pre-Expense Return Results
Now let's look at average total returns. They are more intuitive but they have the problem of survivorship bias, so I put greater stock in the success rates. For returns, turnover does not appear to move the needle for U.S. equities but it does for foreign equities. Over the rolling five-year periods, the lowest-turnover quintile produced average pre-expense returns of 4.6% in U.S. equity. The other quintiles were quite close to that figure: : 4.7%, 4.5%, 4.5%, and 4.1%.

International equity funds did see a difference. The lowest-turnover quintile gained 8.4%, the next one gained 7.8%%, the middle quintile gained 7.4%, and then we go down to a 6.8% gain for the fourth quintile and a 6.6% gain for the highest-turnover quintile.

For balanced funds, results were quite flat, as the middle quintile had the best results--4.7% returns--the lowest-turnover quintile returned 4.5%, and the highest-turnover quintile returned 4.2%. For bond funds, the results were pretty flat across the board as there appeared to be little benefit to picking lower-turnover bond funds. You had a 5.4% return for the lowest turnover quintile and for the highest turnover quintile.

Limits on Turnover
When we use turnover, we are really trying to use it as a proxy for trading costs, and it functions as a poor proxy. Besides the rate of trading, trading costs are also affected by the size of a trade, the liquidity of the stock being traded, and the momentum of the stock. Thus, it helps to think about how big a fund's asset base is when you think about turnover. In addition, you can expect smaller-cap, more-growth-oriented funds to face higher trading costs.

When choosing among large-cap value funds or balanced funds, turnover probably doesn't matter too much. But when choosing among small-growth funds or micro-cap funds, turnover and asset size can be a big deal, as trades can really push stock prices around.

Where Does Turnover Fit In With Other Data Points?
Comparing success rates with those of some of the other data points we've discussed in previous articles will illustrate where turnover fits in. We saw dramatic differences in the quintiles for tests of the Morningstar Rating for funds and expense ratios that put them well ahead of turnover. For example, 5-star U.S. stock funds were 30% more likely to succeed than 3-star funds and 2.2 times more likely to succeed than 1-star funds. For expense ratios, it was a 50% improvement over funds with average fees and a similar 2.2 times improvement over the most expensive quintile. In addition, the combination of low-cost 5-star funds was 60% more likely to succeed than average and 2.6 times more likely to succeed than the bottom quintile.

Performance over manager tenure fared better than turnover. The top quintile of manager records was 20% more likely to succeed than the average and 1.8 times more likely to succeed than the bottom quintile for U.S.-stock funds. Also noteworthy was its showing in taxable-bond funds, where the top quartile beat the bottom quartile more dependably than any other measure.

Investor returns were a notch below manager records but still showed some predictive power, with a 20% improvement on the middle quintile and a 1.7 times greater chance of success than the bottom quintile. In other areas it lagged manager records but still had some value.

Turnover is closer to active share at the bottom of the list. It offered only a 10% improvement over the average active share and a 10% improvement over the quintile with lowest active share. Why did active share fail? Active share tells you how little overlap a fund has with its benchmark. It's helpful in understanding how closely a fund tracks its bogy, but it doesn't tell you about manager skill. If you think about it, you could carve one fund up into 10 smaller funds with greater active share, but collectively the returns would be the same. Or you could cobble 10 funds together into one; collectively, they'd have lower active share but, again, the returns of those 10 combined wouldn't change.

What Turnover Can Tell You About a Fund's Strategy
Turnover is also useful for understanding a fund's strategy. For starters, it tells you about how long-term a manager is really thinking. A manager can claim to be focused on the long haul, but if he is running 100% turnover, you know he is really just focused on the next couple of quarters' worth of earnings reports. This is why high turnover is common among momentum funds.

You might also spot a surprisingly high turnover rate at a fund where the top holdings don't change much. This may be a case where a manager is trading around her positions quite a bit. There's a fair amount of turnover at funds in which managers incrementally sell as holdings reach their fair value or target price and then add when it gets further away.