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Portfolio turnover is more than a question of cost

High portfolio turnover is increasingly being criticised in the context of what it costs investors but there is another, less discussed issue – simple maths suggests fund managers with high turnover are also less choosy

04/05/2018

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Portfolio turnover – in essence, how often a fund manager buys and sells stocks – is often discussed in the context of cost.

This is only right – after all, the more often a manager enters the market to buy or sell, the greater the portfolio’s trading costs, which over time can end up acting as a drag on performance.

There is, however, a lesser discussed consideration: fund managers with high turnover are necessarily less picky.

Less picky 

To illustrate this point, let’s use the highly simplified example of a single fund manager, who takes a week to analyse any business for their portfolio.

Now, let’s give them two weeks off a year and say they run a 50-stock portfolio with 100% turnover – that would mean our manager has to buy every single stock they ever look at, regardless of whether or not they believe it to be a good investment. 

If, on the other hand, the portfolio has a turnover rate of 20% – that is to say, each stock is held for an average of five years – then that means the same manager only needs to buy one out of every 10 businesses they analyse.

And what that means is that the manager only needs to buy the businesses they believe to be genuinely attractive. 

In this simplistic illustration, of course, the fixed resource is the fund manager’s time.

That means they could double the speed of their analysis process to two stocks a week by, say, working 16 hours a day rather than eight or perhaps hiring a colleague.

Whatever route they take, however, the manager with the 100% turnover is always going to have to be less picky than the manager with the 20% turnover.

Greater turnover = less time to be choosy

They become, in effect, the equivalent of a Premiership football club that, on a bad run of form, luck and injuries, is forced to take a deep breath and enter the transfer market.

The club might spend a week with the player on trial, going through tests of fitness, stamina, skills and personality.

At the end of the week, however, it has to stump up the asking price, irrespective of what it found, as it has no choice – the club simply needs a player. Then it must just hope and pray the new guy no-one’s ever heard of turns out OK …

That analogy is admittedly a little harder to extend to investors with very low turnover – such as here on The Value Perspective, for example.

As we discussed in Organisational edge,  over the course of the last 12 months, we have analysed in the region of 300 different businesses and yet, ultimately, we ended up buying a very small proportion of those for our portfolios – somewhere in the region of 3% or 4%.

Then again, maybe such unusual behaviour is not meant to fit an analogy.

As we observed at the time: “Pretty much any other organisation or business that was 4% efficient would soon cease to function. Clearly a restaurant that only used 4% of the ingredients it bought would rapidly go out of business while a factory that was anything less than 80% efficient, say, would likely be shut down by its owners.

“Should they be of a mind to, however, investors can afford to be very picky about which companies they do and do not buy into – indeed, here on The Value Perspective, we would argue the pickier the better.”

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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