Investment portfolio turnover is an important statistic to consider when analyzing an investment portfolio. This consideration should apply to all investment portfolios, whether they are actively or passively managed.

First, Let’s Talk About Mutual Fund Portfolio Turnover

For years, I conducted due diligence on actively managed mutual funds. In my opinion, portfolio turnover was one of the most important statistics to examine. It got to the heart and soul of a manager’s investment style. Was it high turnover or low turnover? This usually depended on his or her investment philosophy and process, and the data and time frames used to make decisions. Also, was the turnover fairly consistent over the years? If it was erratic, this might be an important clue regarding the discipline, or lack thereof, of the process. Understanding turnover provides considerable insight into how a portfolio is managed and should be expected to behave moving forward.

While I was neutral on the high- or low-turnover style of an active management approach, I recognized that both styles could be successful if they were disciplined. I was also aware turnover tended to correlate with other key portfolio statistics.

To start, mutual funds with higher portfolio turnover ratios tended to have higher expense ratios. This was based on the premise that the more active the fund, the higher the expense ratio to provide for additional portfolio activity, such as research, trading, etc. In addition to higher external fund expenses, higher portfolio turnover also unequivocally meant higher transaction costs (which is not captured in the expense ratio). That’s because more trades meant more commissions and more cost slippage through bid-ask spreads; market-impact costs (large trades could move the market and thus have higher transaction costs) also added to expenses. Also, higher turnover often meant higher tax costs if the turnover was not tax-aware. (This is a key distinction as tax-aware portfolios tend to have higher turnover as they aggressively harvest tax losses. To effectively manage a portfolio for after-tax return, one must be aggressively taking losses and incurring portfolio turnover.) All in all, higher portfolio turnover slants the probabilities toward lower portfolio returns over time due to higher costs.

One more key point: Higher portfolio turnover also meant lower confidence in portfolio-based analytics. In other words, the higher the turnover in a fund, the lower my confidence is in its portfolio statistics. For example, if a fund’s last reported portfolio was six months ago but it had 200% annual turnover, that would theoretically suggest not a single position in the portfolio might remain from six months ago. In situations such as these, it was difficult to fully trust portfolio-based analytics when funds had extremely high portfolio turnover.

ETF Portfolio Turnover

Portfolio turnover, meanwhile, is not a statistic often associated with ETF analysis. But, should it be? The median turnover for an equity ETF is approximately 25%. The median portfolio turnover for a mutual fund is about twice that at 50%. It could be argued that it’s not as important, but I would suggest otherwise.

For instance, in the over 160 ETFs that fall under Morningstar’s three domestic large-cap classifications (as of October 2016), there is a clear correlation between portfolio turnover and a variety of key statistics. In short, higher portfolio turnover has a negative correlation to pre-tax returns: the higher the turnover, the lower the total return.

In addition, expense ratios, tax costs, and tracking volatility all have positive correlations. So, a higher-turnover ETF is more likely to have higher expense ratios, higher tax costs, and higher tracking volatility (not tracking the underlying assets net asset value as closely). For a passively managed investment, a fund that doesn’t track well and has higher costs — never mind lower returns, both pre-tax and after-tax — is not very attractive.

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