The Pre-Tax Costs Of Portfolio Turnover

May 01, 2007



Investors who ignore the implications of turnover when selecting investments do so at their own risk. The research conducted for this paper suggests that portfolio turnover has a notable impact on performance, risk and risk-adjusted performance. Investments with higher turnover rates have lower returns and higher risk than those funds with lower turnover rates. Each 100 percent of turnover reduces (pre-tax) performance for Large Cap equity, Mid Cap equity, Small Cap equity and International equity by 19 bps, 45 bps, 80 bps and 98 bps, respectively. The average turnover loss for all categories was 48 basis points for each 100 percent of turnover. Including the tax impact of turnover for taxable investors would further increase the net cost of turnover on investor wealth.

1. This figure is based upon a variety of sources. First, according to the 2006 ICI Factbook, the average broad redemption rate for long-term equity mutual funds from 1985-2005 implies a holding period of 2.78 years. Second, DALBAR's "Quantitative Analysis of Investor Behavior" (2003) found the average holding period for equity mutual fund shareholders was just 29.5 months, or 2.48 years. Third, a report by the Financial Research Corporation found the average holding period for a mutual fund to be 2.4 years. Finally, John Bogle references the three-year figure in a piece for the Financial Analysts Journal (2005).

2. The traditional Sharpe Ratio is calculated as follows: Return (Ret) - Risk Free (RF)/Standard Deviation (Std Dev). The Modified Sharpe Ratio is calculated as: (Ret-RF)/(Std Dev)^((ABS(Ret-RF))/(Ret-RF)). It is important to use Modified Sharpe Ratio when performance is negative. To see why, assume you have two investments: Fund A and Fund B. Fund A has a return of -4 percent and a standard deviation of 4 percent, while Fund B has a return of -8 percent and standard deviation of 8 percent. Fund A is clearly the more optimal investment (higher return and lower standard deviation); however, assuming a risk-free rate of 4 percent, the traditional Sharpe Ratio calculation would for Fund A would be -0.02, compared with -0.01 for Fund B. Therefore, based upon the traditional Sharpe Ratio, Fund B would be considered better than Fund A. However, using the Modified Sharpe Ratio calculation, the Sharpe Ratio for Fund A is -0.0032, compared with -0.0096 for Fund B, which correctly reflects the fact that Fund A outperformed Fund B.

3. Morningstar changed its Foreign Stock asset category in the third quarter of 2003, subdividing the Foreign Stock category into Value, Blend and Growth. For the 2003 test group (since funds that drifted three quarters previous to classification were removed), as long as a fund is characterized as Foreign Stock for the first two quarters, it is not considered to have drifted for the calendar year.


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