Why churn is not necessarily burn

Intuition can be a wonderful thing when we need to make decisions quickly and efficiently. However, what appears common sense at first glance can turn out to be totally wrong on closer inspection.

One particular aspect of the active-passive debate risks falling into this trap.

The final report by the Financial Conduct Authority (FCA) on the asset management industry rightly champions “value for money” but specifically states that it was wrong to interpret their findings as suggesting passive funds are better than active.

However, other commentators on active management are not as measured.

One particular aspect that has drawn the ire of many is the thorny issue of transaction costs. Every time a fund manager buys or sells a share they incur transaction costs. More frequent trading, or higher turnover, increases those transaction costs.

In a world fixated by costs, it is easy to make the next leap and assume that those funds with higher turnover generate worse outcomes for investors. Conventional wisdom is overpowering on this front. But it is also wrong.

Of course it is true that high turnover might indicate low conviction or undue short-termism and trading too often does eat into the returns an active fund delivers for investors.

However, it is unfair to suggest that all turnover is bad.

If a fund manager sells a stock that subsequently underperforms and replaces it with another that outperforms then the impact on performance should be positive, even after allowing for transaction costs.

Conversely, if they hold onto stocks that have been underperforming then this could be a sign of a portfolio based on stale views.

This is not just an assertion. We have spent some time analysing the link between portfolio turnover and excess returns among US-domiciled active equity funds (Churn is not necessarily burn: debunking the myths of portfolio turnover, Schroders, July 20171) and our research dispels this myth.

We found no evidence of a structural relationship between turnover and excess returns among active US equity funds over the 1991-2016 period.

This can be seen in the chart below, which shows the difference each year in returns of the median high turnover US value fund and the median low turnover fund.

Sometimes low turnover funds outperform and sometimes high turnover funds do, without exhibiting any real pattern. Statistical analysis confirms the lack of relationship. This conclusion holds over both one- and three-year investment horizons.

Chart showing no relationship between the churn in portfolios and the performance of investments

Past performance is not a guide to future performance and may not be repeated.

What may be more surprising is that we found no evidence of any relationship across all other styles of US equity fund, even in small caps where the costs of trading are noticeably higher.

On average, high turnover US equity funds have been able to add at least enough value to offset the additional transaction costs they incur. The moral is that pursuing a reduction in transaction costs without considering the consequences is misguided.

Consistency between investment process and turnover is more important than the level of turnover itself. Moreover, it is just as wrong to focus this particular aspect of the debate on active funds alone.

Smart beta indices, the current darling of the investment universe, experience much higher levels of turnover than traditional equity indices.

In the 12 months to 30 June 2017, compared with a 2.6% turnover rate for the MSCI USA index, the US minimum volatility and quality indices run by the same provider had turnover levels of slightly more than 20% while the momentum index had turnover of over 100%.

If cost really is all that matters to some investors, they would do well to read the small print. But before active managers get too comfortable, they are not out of the woods yet on this front.

Emerging market equity funds with consistently higher turnover have, on average, tended to underperform their lower turnover rivals. The best performing emerging market equity funds also typically have lower turnover.

And if you’re going to invest in a fund with a process that results in higher turnover, you had better make sure you choose wisely.

The best high turnover US equity funds outperform the best low turnover funds but the worst do worse and high turnover funds have a statistically significant lower survival rate.

Get it right and the potential gains may be higher, but get it wrong and the downside is also greater.

This issue really gets to the heart of where much of the debate has gone on asset management. It has become wholly focused on costs, where cheaper is assumed to be better. But there are good high-cost funds and there are bad high-cost funds.

I in no way want to downplay the challenge of selecting an active fund manager who will outperform but I do believe that a single-minded focus on cost is unlikely to be the best response. In the FCA’s words, what investors should focus on is value for money.

The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.  Exchange rate changes may cause the value of any overseas investments to rise or fall.

This article was originally published in the Financial Times on 26 July 2017.

1. Analysis covers US-domiciled funds alone for reasons of data availability, as SEC rules require funds to disclose turnover levels. The Morningstar database is used to provide a comprehensive overview of the market. Analysis covers 1991 to 2016 for all funds other than emerging market equities, which covers the shorter 1996-2016 period for reasons of data availability. As an example, analysis of the 2015 calendar year covered over 2,100 funds.

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