Why High Turnover Is Bad

A generic image of a pen on top of a stock chart. Credit: Shutterstock photo

A high turnover rate is not something you want in a stock fund. Let's look at performance numbers to see why. When fund managers frequently trade a stock fund, it produces lower returns than if they trade less than 15% each year.

In "What Is Turnover Rate?" we explained how turnover is the measure of what percentage of the stocks making up a fund are sold and exchanged for new ones each year. We explored how turnover is therefore a measure of the fund manager's belief that short-term trading will produce superior returns. We then explored the relationship between turnover rate, number of holdings, and three- and five-year returns.

In "What Is The Relationship Between Turnover Rate And Number Of Holdings?" we saw the general correlation of greater holdings and less turnover endures for funds with at least 100 holdings. But oddly enough, funds with fewer than 100 holdings had the lowest turnover ratio of all. This caused us to look at how funds with fewer than 100 holdings performed in terms of three- and five-year performance.

In "What Is The Relationship Between Number Of Holdings and Returns?" we learned that funds with fewer than 100 holdings had the worst three- and five-year showings. Having over 500 holdings (generally) produced the best returns.

However, all of these articles dance around the real question: Does actively trading a portfolio produce superior returns? Also, do mutual funds with a lower turnover rate have higher average returns?

I again focused on the turnover rate and three- and five-year returns for all the mutual funds in the U.S. Small Cap Value Morningstar category from Morningstar. There were 407 funds with a three-year return. I split the 407 funds into the following groups based on how much they trade their assets: 0-14% turnover rate (16 funds), 15-24% (43), 25-49% (155), 50-74% (88), 75-109% (59), 110-7,000% (46).

Here is the relationship between turnover rate and three-year annualized returns for actively traded mutual funds as of April 30:

As this chart shows, having a turnover rate under 15% might be worth as much as 2.39 percentage points extra (the difference between the 0-14% turnover group and the lowest performer, the 15-24% one). Once you start actively trading, you might be able to boost returns back up 0.56 point if you trade over 100% a year (the gap between 15-24% turnover and 110%-plus). But the best returns for high-turnover funds were still far lower than for funds with low turnover.

By way of comparison, Vanguard Small-Cap Value ETF ( VBR ) (which we recommend in our gone-fishing portfolio) had an annualized three-year of 18.14% over the period studied in the chart above. Because this exchange traded fund tracks an index (as do most ETFs) - in this case the CRSP Small Cap Value - it trades only to track changes in that benchmark, meaning there's very little turnover.

Here are the five-year annualized returns by turnover rate:

The five-year data show that low turnover is correlated to a higher average return by between 0.69 point and 2.0. Here, the highest turnover rate had the lowest return while in the three-year data it had the highest return among actively traded funds.

Perhaps the lesson is that with a turnover rate greater than 100%, your returns will vary more from the average. But then again, you are just as likely to be at the top as at the bottom. Infrequently traded funds on average managed to outperform all others, while the funds that got the most attention and trading from their managers switched from the highest returns for active trading in the short-term to the lowest returns in the long-term.

Meanwhile, Vanguard Small-Cap Value ETF had an annualized five-year return of 13.42% over this period.

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David John Marotta, CFP, AIF, is president of Marotta Wealth Management Inc. of Charlottesville, Va., providing fee-only financial planning and wealth management at www.emarotta.com and blogging at www.marottaonmoney.com. Both the author and clients he represents often invest in investments mentioned in these articles.

AdviceIQ delivers quality personal finance articles by both financial advisors and AdviceIQ editors. It ranks advisors in your area by specialty, including small businesses, doctors and clients of modest means, for example. Those with the biggest number of clients in a given specialtyrank the highest. AdviceIQ also vets ranked advisors so onlythose with pristine regulatory histories can participate. AdviceIQ was launched Jan. 9, 2012, by veteran Wall Street executives, editors and technologists. Right now, investors may see many advisor rankings, although in some areas only a few are ranked. Check back often as thousands of advisors are undergoing AdviceIQ screening. New advisors appear in rankings daily.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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