The image of the wheeler-dealer fund manager has understandable appeal. If a manager isn't trading every day, why pay a 1.5% annual fee? He or she has to earn that million-dollar salary by making moves, right? Maybe not. We've often heard value managers say the best thing they can do is take a vacation and forget about their portfolios. Time spent away from the office helps them keep a long-term perspective and forces them to be patient. Indeed, the most successful investor of our time, Warren Buffett, is a paragon of the buy-and-hold approach and his longtime disciples Bill Ruane and Richard Cunniff of Sequoia Fund have racked up a breathtaking record of top-decile returns without doing much trading at all. These observations raise a simple but critical question: Does low turnover produce better results?
A performance comparison for domestic stock funds suggests the answer is yes. In general, the lower a fund's turnover, the higher its returns. This relationship is statistically significant, and it holds up for all four of the time periods measured:
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| < | 20% | 27.01 | 23.90 | 17.15 | 12.87 | ||
| 20%-50% | 23.07 | 21.90 | 16.59 | 12.52 | |||
| 50%-100% | 21.81 | 21.77 | 17.01 | 12.62 | |||
| > | 100% | 17.55 | 19.74 | 15.02 | 11.29 | ||
Although these numbers suggest that simply opting for low-turnover funds is a surefire way for investors to better their returns, it's not that simple. As it turns out, the effects of portfolio turnover vary based on investment style. To isolate the impact of turnover based on style, we ran a linear regression of fund returns against turnover within each square of the domestic-equity style box for each year from 1992 through 1996. The following graph shows the amount of returns that are added or subtracted for each unit (where 100% turnover represents one unit) of turnover:.
Turnover has clearly done the most damage to large-cap value and blend funds. Indeed, the general finding that high turnover results in lower returns derives in large part from the fact that these funds represent nearly 40% of domestic equity funds. In other areas of the style box, however, managers have added returns through turnover. For example, with each unit of turnover, the average small-cap value and growth fund has seen its returns pumped up by 143 basis points or more. Thus, the criticism that Garrett Van Wagoner receives for his frequent trading in such small-cap growth funds as Emerging Growth may be unfounded.
Overall, the clearest pattern is that the benefits of turnover decrease as risk levels decrease--turnover has been more rewarding in the high-risk segments of the style box. This relationship makes sense. The more volatile the stock, the better the chance that smart trading can bring in substantial gains, or avoid crippling losses. Indeed, in a fast-moving market, a suddenly unpopular stock can lose 50% or more of its value in a matter of days (or hours). The Van Wagoner funds offer an anecdotal example. Early this year, Van Wagoner sold Citrix Systems, a fast-growing tech stock he held in the Emerging Growth fund, at a profitable $50. The stock subsequently fell to $10 after disappointing news about the company, at which point he got back in. The stock has since returned to $50. More often than not, small-cap growth funds are investing in rapidly changing industries such as technology, where buying a hot stock at the right time--and, even more critically, getting out of it before it cools--can add real value.
The dynamics of the smaller-cap market, however, contrast highly with those of the large-cap market. It's unlikely that one large-cap manager will know a lot more about the near-term prospects of Philip Morris than another, and hence, they're unlikely to trade profitably on that knowledge. Rather, large-cap managers excel by recognizing long-term trends that others may not see. Warren Buffett, for example, astutely saw Coke's strong international potential while Wall Street saw only flagging domestic sales. There's also the issue of size. Large-cap value funds, for example, cart around asset bases of close to $800 million on average, while small-cap funds tend to have smaller asset bases. Rapid trading is cumbersome for larger funds, and a profitable trade has only diluted impact on overall returns.
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