The Sad Truth Behind Turnovers (Or Why The NFL Matters In Investing) by Tom Macpherson, Dorfman Value Investments
If you were to take a look at the teams with the best records in the NFL, you would see they have some of best turnover ratios (giveaways versus takeaways). Turnovers drive coaches crazy. They do so because it’s the easiest way to self-destruct or to defeat yourself before your opponent has even taken a crack at you. Good teams occasionally turn the ball over. Great teams apply super glue to their possessions. And the worst teams seemingly hand the ball over like Thanksgiving Day leftovers. For instance through week 16 of the 2015-2016 season the teams with the best turnover ratio (meaning lowest turnovers per game) were Carolina, Kansas City, Cincinnati, Arizona, and New England. Not bad company to keep.
What if I told you that turnover in the investing world is no different than the NFL – that in general the higher the turnover the worse your performance? That’s a key finding in a 2013 study published in the Financial Analysts Journal, by Roger Edelen, Richard Evans, and Gregory Kadlec. The researchers studied 1,758 domestic equity mutual funds and analyzed available information to estimate trading costs (brokerage fees, bid-ask spreads, etc.) from 1995-2006. Their findings were interesting to say the least. First, the average cost of trading was 1.44% per year. This is more than half of all mutual funds’ management fees. Second, fees were dramatically different by market cap. For instance, small cap funds paid an average of 3.17% per year where as large cap funds paid 0.84% per year. When your average small cap fund charges 1.68% for a management fee and 3.17% in trading costs, it is extraordinarily difficult to beat an index fund with no trading costs and a very small management fee. Last, in almost all cases the more you traded the worse your return. This is the opposite of why we are told high frequency trading is a boon to investor returns. Research found “a strong negative relation between aggregate trading cost and fund return performance.” Specifically, the funds in the highest quintile for trading costs (the funds that had the most significant costs) underperformed those in the lowest quintile by an average of 1.78 percentage points per year. Some examples of high turnover funds with such performance are as follows:
Note: The Named Fund returns are compared against the S&P 500 Total Return Index. In some cases the fund does not have a 3 or 5 year return.
Why This Matters
For individual investors, this type of research can provide valuable insights into the development and management of our own portfolios. While many of us won’t manage a portfolio with 1,000 – 1,500 stocks, many might manage a portfolio with 100 stocks. Even at that size two issues are vital to achieving long -term market outperformance.
Costs Matter: The simple fact is costs add up and can play a huge part in future returns. Every dollar spent in trading is lost to the power of compounding. Don’t think that matters? Let’s say you invested $10,000 in two portfolios of 100 stocks with each charging a 1% management fee. One portfolio had 10% turnover and the second 100% annual turnover. Also let’s assume each trade costs $10. Finally let’s assume each portfolio achieved an average 8% gross annual return for 30 years.
At the end of the period the Low Turnover Fund would have $331,381 in assets. The High Turnover Fund would have $277,985 or exactly $53,396 less. And this is assuming both funds achieved the same returns. According to Edelen et al. the highest turnover funds generally underperformed low turnover funds. If we decrease the High Turnover Fund to 4% annual return the fund would end up with $200,005 or $131,376 less than the Low Turnover Fund. Costs do indeed matter.
Knowledge Matters: At Dorfman Value we take a great deal of time researching potential investments including financial modeling, competitive research, etc. We maintain a relatively focused portfolio of roughly 25 stocks. We do this mostly because it is extremely difficult to bring enough expertise to bear if you truly want to understand the company behind the stock.
In the case of the High Turnover portfolio this means understanding roughly 8 companies per month. And this is on the buy side only. You need to understand another 8 well enough to choose which stock to sell. So every 30 days your team must be comfortable enough to make a measured and objective decision on 16 companies. It’s no wonder that high turnover funds also generally have extremely high management fees.
Conclusions
Many people driving down the highway see signs that say something along the lines that Speed Kills. In our investing world turnover kills. If you think you can trade heavily (greater than 125% – 150% turnover) and outperform the markets you are fighting an uphill battle. It is far more than likely you will underperform and provide a terrible disservice to yourself and your investors. At Dorfman Value we believe in investing in great companies for very long periods and let management and the markets do the heavy lifting. We highly recommend you emulate some great NFL coaches like Bill Belichick or Pete Carroll. Your returns will be the better for it.
