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| Running Hard to Fall Behind |
| Scott Cooley, 6-6-2002 |
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On Sept. 30, 2000, Fidelity Destiny I's top-10 holdings included Microsoft,
Wal-Mart Stores, General Electric, Pfizer, Microsoft, and Fannie Mae. The fund
reported a turnover rate of 119% during the subsequent fiscal year, which ended
Sept. 30, 2001, implying that manager Karen Firestone had turned over the entire
portfolio and then some. But at the end of the period, the fund's top-10
holdings hadn't changed much. They included Microsoft, Wal-Mart Stores, General
Electric, Pfizer, Microsoft, and Fannie Mae. What gives? Morningstar analysts
frequently notice that managers running funds with high turnover rates sometimes
tend to own the same names year after year. Rather than making wholesale shifts,
they're constantly tweaking their position sizes, adding to a fund's stake in a
stock, and then trimming it.
According to managers we have spoken with, the justification for such trading
goes like this: In the volatile markets of recent years, a manager simply can't
afford to sit still. With prices gyrating wildly, a savvy manager can take
advantage of the market's volatility, buying a stock on dips and selling into
upward moves. For example, the prices of even relatively stable behemoths such
as GE, which has the largest market cap of any domestic stock, have spiked and
plummeted over the past year. For the 12 months through April 30, 2002, GE's
stock had traded as low as $28.50 and as high as $53.55 – a huge spread in
percentage terms. Some managers also argue that this volatility requires shorter
holding periods in general – so stocks may enter and exit their portfolios in a
matter of weeks or months, as they take advantage of short-term trading opportunities.
The logic of fast-trading managers may sound appealing, but there are also
compelling arguments against ratcheting up turnover. Aside from the potentially
large tax consequences of frequent trading, it's worth keeping in mind that
trading stocks isn't without cost. Sure, institutions pay very low commissions,
but those transaction fees, however small, are still expenses that come right
out of funds' returns. More significantly, there are market makers who profit
from stocks' bid/ask spreads, taking a cut of each trade. And managers of big
funds must contend with the market impact of their trading: They tend to push
up stock prices when they're buying, then drive them down when they sell – which
harms their funds' returns. Investors don't often think about those costs – and
they're exceedingly difficult to quantify – but they are nevertheless real.
In our view, logic favors the argument against rapid trading, and a comprehensive
look at the issue reinforced our bias toward buy-and-hold funds. In short, some
fund managers’ frenetic trading is costing their shareholders a lot of money. |
Our Methodology |
With the invaluable assistance of Morningstar research analyst Stephen
Murphy, we attempted to see how frequently managers trade in and out of
stocks and whether they had been able to add value with their extra
trades. Murphy selected the most-recent portfolio filed by each
domestic-stock fund, and then retrieved another portfolio for each
fund from one year earlier. Taking into account the appreciation or
depreciation of the individual securities in the earlier portfolio,
he constructed hypothetical holdings for each fund as of the latter
date, in an attempt to simulate what the portfolio would look like
had the manager simply bought and held. He then compared that
hypothetical portfolio with the fund's most recent list of holdings.
He was therefore able to calculate the percentage of the portfolio
that had changed over the past year.
For the second step, we compared the percentage change in the fund's
holdings over the year with the reported turnover rate. Note that
these two figures are not identical. By the SEC definition, a fund's
turnover rate is the lesser of purchases or sales divided by the
average monthly net assets of the fund. Given the tendency of some
managers to trade into and out of individual positions, that reported
turnover rate is often far higher than our custom turnover rate.
And in a minority of cases, the SEC turnover rate may be lower than
the rate we calculate. To illustrate that, let's use a rather
simplistic example. Take a fund that begins with just 10 securities,
then meets shareholder redemptions by selling off half of its holdings.
Our hypothetical fund buys no stocks during the period. By the SEC
definition, the fund's turnover during the year was zero, but by our
calculation, 50% of the portfolio has changed.
We wanted to aggregate the performance of funds that do little
trading in and out of positions, then compare that with the returns
of offerings whose managers do a lot of “extra” trading. As a final
step, we therefore segregated funds by the difference between their
reported portfolio turnover rates and the real turnover in the portfolios. |
The Findings |
Some funds have enormous gaps between their reported turnover rates
and the percentage change in their portfolios. For the highest-trading
quartile of funds, the median gap between reported turnover and the
actual percentage change in the funds' holdings was 140 percentage
points. Among the funds with the highest gap between reported and
real turnover rates were offerings such as Nicholas-Applegate Global
Health, Turner Technology, Strong Large Cap Growth, and Conseco Twenty.
These funds own many of the same individual stocks as they held a year
earlier, but their turnover rates implied they'd turned over the
portfolio several times. Overall, we calculated the average fund's
real turnover was 39 percentage points lower then its reported turnover
rate.
Let's walk through an example of how this works in practice. John
Wallace of RS Midcap Opportunities is a frenetic trader who frequently
adjusts position sizes. For example, he owned zero shares of Ocean
Energy in December 1999, bumped up his stake to 175,000 shares by
mid-year 2000, then sold it down to zero later in 2000. By mid-2001,
he had again accumulated a 175,000-share stake, which he trimmed to
70,000 at the end of 2001 and raised to 75,000 shares as of March 2002.
That said, many funds had similar reported and real turnover rates. As
one might expect, index funds like Vanguard 500 Index didn't do a lot
of extra trading. Ditto for big, broadly diversified active funds.
For example, Fidelity Magellan and nearly any fund offered by Capital
Research & Management’s American Funds had very small gaps between
their SEC and real turnover rates. Funds that keep their trading in
check appear to generate better returns for shareholders. Over the
past year, the results have been striking. Within the quartile of
funds that did the greatest amount of extra trading, the typical fund
trailed 55% of its category peers. Within the quartile of funds with
the smallest gap between real and reported turnover rates, the median
fund beat 59% of its rivals.
The results held over the long term, too. Over the trailing three-
and five-year periods, the funds with the greatest reported turnover
rates, in relation to the actual changes in their portfolios, tended
to post the worst returns, in terms of their percentile ranks. One
might argue that poor performance produces higher turnover, as managers
are forced to sell securities to meet redemptions. To test this
hypothesis, we re-ranked domestic-stock funds by their 1998 turnover
levels, again segmenting them according to the gap between their real
and reported turnover levels. Once more, the groups with the least
extra trading had an edge. |
Using the Findings |
Do we expect investors to set up an elaborate program to replicate
this study, using it to select funds of their own? Of course not.
But if a fund you're contemplating buying reports a high turnover
rate, try to make sure the manager is using his or her trading
discretion to good effect. ICAP Select Equity's Rob Lyon is one of
the most frenetic traders around, but he has a proven ability to
take advantage of short-term opportunities the market presents.
If Lyon lacked the long, terrific track record he has amassed,
we'd probably take a pass on his fund.
A careful look at a few of your funds' shareholder reports can help
determine whether a manager is trading a lot in an effort to add
value. The obvious sign is a turnover rate that lands well into
the triple digits. Moreover, if a fund's reporting a triple-digit
turnover rate, but you're seeing the same names in the portfolio
year after year, the manager is probably trading in and out of
stocks in an effort to add value. Based on our findings in this
study, that’s likely not a good thing. Finally, although the
aggregate numbers make a case against managers who trade into and
out of positions, it's worth keeping in mind there are some cases
when extra trading is a plus. For example, some managers keep a
close eye on tax efficiency, and they may be quick to sell stocks
to book tax losses, even though they later plan to buy back the
same shares. That trading activity will likely benefit shareholders
in taxable accounts.
Overall, however, it’s clear managers who trade in and out of stocks
are subtracting value. While some managers probably earn returns by
trading at the expense of others, the odds are surely stacked against
them. Knowing your managers keep extra trades to a minimum isn't a
guarantee of success, but it gives them a fighting chance.
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| Copyright © 2008 ReFlow Management Co., LLC |
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