Saturday, June 17, 2000
The Sophisticated Investor
Velocity of turnover can be key variable
By John Waggoner
In this world, we are surrounded by the forces of evil. There's crime. There's violence. There are mutual fund managers who trade too much.
But before we condemn hyperactive fund managers to the Outer Darkness, we should stop and ask: Is a high level of trading actually a bad thing in a fund? Except for the most extreme cases, the answer is probably no.
No one disputes that mutual fund managers do a lot of trading certainly more than the typical individual.
The most common measure of a fund's trading activity is turnover. The average stock fund has annual turnover of 91 percent, according to Lipper, which tracks the funds. A fund with 100 percent turnover doesn't necessarily trade all of its stocks in a year. It could trade just a few stocks many times. But the higher the turnover, the more trading a fund does.
And a 91 percent turnover rate is high by most people's standards. Jack Bogle, iconoclastic founder of the Vanguard Group, doesn't think much of high turnover. In an April 6 speech, he said:
We have the power to choose whether we will be long-term investors or short-term speculators. With its 90 percent portfolio turnover, the fund industry has chosen short. My own chips are on "long.'
In a recent interview, he had these knocks against turnover:
Funds and their related advisory services own about 35 percent of all stocks, he said. So it's not reasonable to assume that 60 percent of all their trading is between each oth er. Trading costs money, and much of that trading is to no great advantage to the shareholder. With all that gambling, someone is raking off part, he said. Mr. Bogle doesn't think it's the shareholder.
Taxes. When managers trade stocks, they generate capital gains and losses. It's horribly tax-inefficient, he said. About a third of the gains generated by funds are short-term gains, which are taxed at ordinary income tax rates.
Philosophically, he's right. It's good to invest for the long term. Unfortunately, the record hasn't been kind to buy-and-hold mutual funds recently.
We looked at the 100 diversified U.S. stock funds with the highest turnover, and compared them with the 100 funds with the lowest turnover. Some of the high-turnover funds had mind-boggling trading levels. Vertex Contrarian, for example, led the pack with a 1,553 percent turnover. These 100 hyperactive funds had a median turnover half higher, half lower of 331 percent.
So how did they do? Not bad. They produced an average 52.3 percent gain the past 12 months vs. 24 percent for the average stock fund. The past five years, they averaged a 175 percent gain vs. 157 percent for the average stock fund.
The 100 funds with the lowest turnover had a median turnover of just 3 percent. They averaged a 12.9 percent gain the past 12 months and 150 percent the past five years.
What gives? In large part, it reflects the recent drubbing that growth funds have given value funds. The past five years, large-company growth funds, which tend to be active traders, have soared 224 percent. Large-company value funds, which are more patient investors, are up 141 percent.
So what's an investor to do? First, be alarmed if a value fund shows high turnover. It could mean the fund's style is shifting. And Mr. Bogle has a disconcerting ability to be right in the long term.
So look for a fund with good returns and low turnover. Naturally, that would start with an index fund. But some actively managed funds also offer infrequent trading and good returns.
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