Swedroe: Turnover, Returns Can Coincide

A look at a study reviewing the relationship between turnover and returns.

While there has been a strong and persistent trend toward passive investing, actively managed funds still control the lion’s share of assets under management.

Lubos Pastor, Robert Stambaugh and Lucian Taylor contribute to the literature on actively managed mutual funds with their study “Do Funds Make More When They Trade More?”, which appeared in the August 2017 issue of The Journal of Finance. Their research focused on the question of whether active equity fund managers have skill.

To answer it, they examined the trading behavior of actively managed mutual funds. The authors hypothesized: “A fund trades more when it perceives greater profit opportunities. If the fund has the ability to identify and exploit those opportunities, then it should earn greater profit after trading more heavily.”

Turnover & Returns

Their study, which covered 3,126 active U.S. equity mutual funds from 1979 through 2011, benchmarked active fund performance against the index assigned by Morningstar. Following is a summary of their findings:

• A fund’s turnover positively predicts the fund’s subsequent benchmark-adjusted return. The typical fund performs better after it trades more.
• Funds holding small company stocks, or small-cap funds, have a significantly stronger turnover-performance relation than large-cap funds.
• There’s a stronger relation for small funds than large funds, consistent with the ability of smaller funds to trade less-liquid stocks, given that smaller funds tend to trade in smaller dollar amounts.
• A one-standard-deviation increase in turnover is associated with a statistically significant 0.66% per year increase in performance for the typical fund.
• The findings are robust in the subperiod 2000 through 2011.
• The findings were similar when the active funds were benchmarked against the Fama-French three-factor model (market beta, size and value), the Fama-French four-factor model (adding momentum) and the Fama-French five-factor model (market beta, size, value, investment and profitability).

Additionally, Pastor, Stambaugh and Taylor hypothesized that funds should trade more when profit opportunities were better; that is, during periods with more mispricing. They used three proxies for mispricing:

• Sentiment: Sentiment-driven investors participate more heavily in the stock market during high-sentiment periods, creating a greater likelihood of mispricing. They found sentiment explains a large degree of the time variation in fund turnover.
• Volatility: Higher volatility corresponds to greater uncertainty about future values and, thus, greater potential for investors to err in assessing those values. Their findings were consistent with this prediction.
• Liquidity: Research has shown that liquidity is positively correlated with market efficiency. Specifically, periods of lower liquidity are more susceptible to mispricing. They found that despite the higher trading costs, turnover increased during periods of low liquidity.

The bottom line is that the authors found funds trade more when there is more mispricing. What was perhaps most interesting is that they found no evidence funds were trading to exploit any of the 11 well-known anomalies they investigated: two measures of financial distress, two measures of stock issuance, accruals, net operating assets, momentum, gross profitability, asset growth, return on assets and the investment-to-assets ratio.

This led them to conclude: “To the extent that funds trade more when there is more mispricing, they are exploiting mispricing beyond these eleven anomalies.”

Costs Impact Outcomes

Also of interest was that Pastor, Stambaugh and Taylor found the relation between turnover and performance is stronger among expensive funds. That more-skilled funds charge higher fees is consistent with economic theory.

As Jonathan Berk pointed out in his paper, “Five Myths of Active Portfolio Management,” when capital is supplied competitively by investors but ability is scarce, only the participants that have the skill in short supply can earn economic rents.

Investors who choose to invest with active managers cannot expect to receive a positive excess return on a risk-adjusted basis. If they did, there would be an excess supply of capital to those managers.

Their findings led Pastor, Stambaugh and Taylor to conclude: “Funds seem to know when it’s a good time to trade.” They also concluded that turnover is related to mispricing in the stock market.

Furthermore, they found that average turnover across mutual funds “is significantly related to three proxies for potential mispricing: investor sentiment, cross-sectional dispersion in individual stock returns, and aggregate stock market liquidity. Funds trade more when sentiment or dispersion is high or liquidity is low, suggesting that stocks are more mispriced when funds collectively perceive greater profit opportunities.”

Unfortunately for believers in active management as the winning strategy, as Berk also explained, evidence of skill doesn’t mean investors will benefit from that skill. Due to fees and decreasing returns to scale (outperformance leads to inflows of cash and return persistence disappears), the research shows that skill does not equate to risk-adjusted outperformance for investors.

Higher Skill Is Not Better Performance

For example, in the study “Scale and Skill in Active Management,” which appeared in the April 2015 issue of the Journal of Financial Economics, Pastor, Stambaugh and Taylor found that while the average fund’s skill has increased substantially over time, from -5 basis points (bp) per month in 1979 to +13 bp per month in 2011, this higher level of skill has not translated into better performance.

The authors reconciled the upward trend in skill with no trend in performance by noting: “Growing industry size makes it harder for fund managers to outperform despite their improving skill. The active management industry today is bigger and more competitive than it was 30 years ago, so it takes more skill just to keep up with the rest of the pack.”

As further evidence that fund manager skill doesn’t necessarily result in superior returns to investors, Jonathan Berk and Jules van Binsbergen, authors of the study “Measuring Skill in the Mutual Fund Industry,” found that while the average mutual fund has added value by extracting about $2 million a year from financial markets, the average net alphas (after expenses) were negative.

For example, for domestic stocks, value-weighted net alpha was -5 basis points per month compared to Vanguard benchmarks, and -8 basis points per month compared to risk-adjusted benchmarks.

When combined with prior research, the findings from Pastor, Stambaugh and Taylor present compelling evidence that active mutual fund managers possess skill.

Of course, because active investing is a zero-sum game before expenses, there is also evidence that retail money lacks skill (retail investors are the proverbial suckers at the poker table, and it’s likely they don’t know it or they would stop playing).

However, the research shows that, once fund expenses are taken into account, active fund investors earn below-benchmark returns. That makes active management the loser’s game despite the skill advantage the fund industry possesses. In other words, the beneficiaries of that skill, those earning the economic rent, are the fund sponsors, not the investors.

Societal Benefits

It’s also important to note, as Pastor, Stambaugh and Taylor do, that active management provides important societal benefits.

They write: “Heavier trading by funds when mispricing is more likely underscores the role of active management in the price discovery process. While the active management industry may not provide superior net returns to its investors (consistent with both theory and evidence), it creates a valuable externality. The combined trading of many funds helps correct prices and thereby enables more efficient capital allocation.”

We can view the costs of active management as a societal cost of price discovery. This begs the question: How much active management do we really need to ensure market efficiency and the efficient allocation of capital? Surely, it must be far less than the thousands of actively managed mutual funds that today represent about $13.5 trillion in assets under management and about 10,000 hedge funds with another $3 trillion under management.

Efficient Capital Allocation

Fifty years ago, there was a small fraction of the number of mutual funds we have today, and the hedge fund industry was still in its infancy. Yet the market seemed to function quite well and capital was allocated efficiently.

And you certainly weren’t hearing complaints about passive investing like those from Sanford C. Bernstein & Co. strategist Inigo Fraser-Jenkins in his note titled “The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism.”

I suspect the real reason for complaints about the trend to passive investing (and they always seem to come from active managers) is that their livelihoods are threatened, not the best interests of investors.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.