The impact of costly turnover
Other activities can add substantially to a mutual fund’s overall cost burden. Equity trading costs, such as brokerage fees, bid-ask spreads,1 and price impact, can be just as large as a fund’s expense ratio. Trading costs are difficult to observe and measure, but they impact a fund’s return nonetheless—and the higher these costs, the higher the outperformance hurdle.
Among equity funds, portfolio turnover can offer a rough proxy for trading costs.2 Managers who trade frequently in their attempts to add value typically incur greater turnover and higher trading costs. Although turnover is just one way to approximate trading costs, the study indicates that funds with higher turnover are more likely to underperform their benchmarks.
In Exhibit 5, equity funds existing at the beginning of the five-, 10-, and 15-year periods are placed in quartiles based on their average turnover. Turnover varies dramatically across equity funds, reflecting many different management styles. For the most recent five- year period, funds in the low-turnover quartile averaged 17% turnover. The average turnover for the highest quartile was 185%, more than 10 times higher.
Funds with high turnover have lower rates of outperformance. For the five-year period, 33% of funds in the lowest quartile beat their benchmarks, while only 20% in the high-turnover quartile had winning performance. The principle also applies to 10- and 15-year periods, with fewer winners among the high-turnover quartiles.
This analysis of US mutual fund performance illustrates the obstacles confronting investors seeking outperforming funds.
- For the periods examined, the research shows that: Outperforming funds were in the minority.
- Strong track records failed to persist.
- High costs and excessive turnover may have contributed to underperformance.
These results are consistent with a market equilibrium view of investing. Intense market competition drives securities prices to fair value, making it difficult to persistently add value by identifying mispriced securities. Despite the best efforts of many professionals working in the industry, the vast majority of funds fail to outperform their benchmarks.
Although the odds are stacked against them, many investors continue searching for winning mutual funds and look to past performance as the main criterion for evaluating a manager’s future potential. In their pursuit of returns, many investors surrender performance to high fees, high turnover, and other costs of owning the mutual funds.
The underperformance of most US mutual funds highlights an important investment principle: The capital markets do a good job of pricing securities, which makes beating benchmarks (and other investors) quite difficult. When fund managers charge high fees and trade frequently, they must overcome high cost barriers as they try to outperform the market.
Choosing a long-term winner involves more than seeking out funds with a successful track record, as past performance offers no guarantee of a successful investment outcome in the future. Moreover, finding past performance is only one way to evaluate a manager.
Investors should consider other variables, including a mutual fund’s underlying market philosophy, investment objectives, and strategy. They should also consider a mutual fund’s total costs, including trading costs, which may be affected by the manager’s approach.
US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago.
Certain types of equity and fixed income funds were excluded from the performance study. For equities, sector funds and funds with a narrow investment focus, such as real estate and gold, were excluded. Money market funds, municipal bond funds, and asset-backed security funds were excluded from
Funds are identified using Lipper fund classification codes. Correlation coefficients are computed
for each fund with respect to diversified benchmark indices using all return data available between January 1, 2000, and December 31, 2014. The index most highly correlated with a fund is assigned as its benchmark. Winner funds are those whose cumulative return over the period exceeded that of their respective benchmark. Loser funds are funds that did not survive the period or whose cumulative return did not exceed their respective benchmark.
Expense ratio ranges: The ranges of expense ratios for equity funds over the five-, 10-, and 15-year periods are 0.01% to 4.89%, 0.01% to 4.53%, and 0.04% to 4.83%, respectively. For fixed income funds, ranges over the same periods are 0.01% to 2.78%, 0.05% to 2.55%, and 0.03% to 3.66%, respectively.
Portfolio turnover ranges: Ranges for equity fund turnover over the five-, 10-, and 15-year periods are 1.0% to 1,499.4%, 1.0% to 1,524.0%, and 2.0% to 2,400.4%, respectively.
Benchmark data provided by Barclays, MSCI, Russell, Citigroup, BofA Merrill Lynch, and S&P. Barclays data provided by Barclays Bank PLC. MSCI data © MSCI 2015, all rights reserved. Russell data © Russell Investment Group 1995–2015, all rights reserved. Citigroup bond indices © 2015 by Citigroup. The BofA Merrill Lynch index is used with permission; © 2015 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. Merrill Lynch, Pierce, Fenner & Smith Incorporated is a wholly owned subsidiary of Bank of America Corporation. The S&P data is provided by Standard & Poor’s Index Services Group.
Benchmark indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.
1. Bid-ask spread is the difference between the highest price a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it.
2. Fixed income funds are excluded from the analysis because turnover is not a good proxy for fixed income trading costs.