Most of my posts end
with a question to our readers. I ask questions not only to promote a dialog,
but more importantly to learn from some pretty smart people who regularly read
these posts. Last week one of the long-term members of this community sent me a
series of thoughtful questions. One of which was, “When you conduct your analysis
of funds and manager(s), how important is portfolio turnover in your
calculation?” In effect, he is asking, do turnover rates matter?
When an investment
analyst is asked this type of question you should not be surprised that the
answer is “yes and no with an explanation.”
A compliance invention misused
The earliest use of the
term turnover rate was by the US Securities and Exchange Commission (SEC) in
required prospectus disclosure. (As I hope to be visiting our British friends
shortly, I need to distinguish between the US use of the term and UK’s use of turnover
as a synonym for sales.) The SEC’s prospectus requirement was not designed as a
selection tool to pick funds. The purpose of the calculation was to spot
excessive churning of a portfolio to generate, what used to be valuable
brokerage commissions. This purpose will become clearer when one knows the
methodology of the calculation which is take the smallest of aggregate purchase
dollars or sales divided by the monthly average of total net assets. Now you
have learned more than you ever wanted to know about turnover rates.
Turnover
is a good place to start asking questions
Portfolio
turnover is an important place to start, but perhaps more important is
personnel turnover which I will discuss further below. In terms of portfolio turnover
data, when I talk with portfolio managers the following questions are asked:
1. On balance are they selling losers or
winners?
2. What is the average length of time before
transacting?
3. Is the average length of time different
for the winners and losers?
4. Do they do any post-transaction analysis
to see in the succeeding six or twelve months whether the decision was a good
one?
5. In general, what did the transactions do
to the portfolio?
6. How does the current turnover rate compare
with those in the past and does this have any particular significance?
There are other
questions that are then asked about the research behind particular positions in
the portfolio. However, if the Portfolio Manager (PM) does not have answers to
most of the turnover questions above, I find it difficult to have the requisite
confidence in the fund for it to be owned by my clients.
There is an important
caveat about turnover rates that needs to be recognized. That is they seem to
be rising; meaning that the weighted average in the portfolio is being held for
a shorter period of time. One of the reasons for this is the
consultants'/selectors' “Three Year Fallacy.”
Under normal conditions three years is only a portion of an investment
cycle. Four years fits closer to the
historical trends and normally contains a US Presidential cycle. Actually the
command economies have favored a five year period for their planning. I
personally prefer a ten year period which would give ample time for a recovery
from a management mistake. Enough of the numerology, the real reason for the
intermediaries to focus on three years is that it is the shortest period that
they can earn a new fee for a search to replace a poorly performing manager. (Often
there is a substantial relative performance recovery after a three year period.
This could be caused by redemptions that are forcing the PM to sell and often
he/she sells some positions that didn’t do as well as expected in the recovery.)
There is a second and
more structurally dangerous factor causing turnover rates to rise. I have been
on non-profit investment committees who are doing a good job meeting the twenty
or more years need for funding. They invest for the long-term and review their
performance intensively once a year and less so quarterly. Because of the long-term
nature of their tasks they will put up with a number of underperforming periods
before they switch investments. That period of disappointment might last five
years or 20 quarters. Today we have the ability to get publicly traded
portfolio performance monthly, weekly, daily and perhaps even hourly. If it
took 20 observations for the long-term manager to finally terminate a fund, the
same number of unhappy reports could occur in a month of twenty trading days or
a year and eight months if monthly numbers are the trigger.
Hopefully owners of
accounts in funds and/or individual securities will be mature enough not to be
solely driven by performance numbers and will pay attention as to what is
happening within the portfolio and within the investment organization.
The
important turnover report: Personnel
In our meetings with
various fund groups we are sensing many more portfolio managers being switched
than what we have seen in the past. The same
trend is also being noted by Citywire outside of the US, where at the current
rate by year-end over 1000 portfolio managers will be replaced. Several US
organizations which have been remarkably stable for years are now experiencing portfolio
manager turnover. Some of this may be due to financial or psychic compensation
or in a number of instances, performance problems. In some cases these changes
are not disclosed. What is definitely not disclosed is the turnover in
analysts. Only at a recent face to face meeting with a PM did we learn about a
reduction in the number of analysts in the office. (Interesting enough the PM
believes that it could help improve the quality of investment research and
decisions.)
The turnover of senior
officers in a firm is important to me. Recent turnover of CFOs has caught my
attention as these are not just bookkeepers but play critical roles in
developing and carrying out corporate strategies. Rarely do we see
announcements of critical changes on the trading desks at institutions. For
many funds that have a high portfolio turnover and/or invest in small or micro-caps,
the traders can add great value. This also true in the fixed income and credit
markets.
Is
turnover important?
Yes, the context of the
turnover in the portfolio and in the organization is important, but the number
itself can be misleading.
How
do you view turnover?
Please let me know
privately or publicly.
I am looking forward to
seeing some of you in London in September.
______________________
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