Cutting costs is the name of the game for passive investors, so watch out for the effect of Portfolio Turnover Rate (PTR) on your trackers.
For all the focus on Total Expense Ratios (TERs) – the headline measure of a fund’s expense – they’re only the tip of the cost iceberg for products with a high turnover rate.
Portfolio turnover portends1 your fund’s exposure to stealth costs like:
- Bid/offer spreads
- Commissions
- Stamp duty
- Price impacts
These costs aren’t high on many investor’s radars, but they will together knock a chunk off your return.
What is turnover?
The portfolio turnover rate measures how often a fund’s securities are bought and sold within a 12-month period.
For example, a PTR of:
- 100% = the average asset in the fund portfolio is bought and sold every year.
- 50% = the average asset is bought and sold every two years.
- 200% = the average asset is bought and sold every six months.
PTR has a very simple cause and effect: The higher the PTR, the more often securities are traded, and so the greater the costs incurred.
These transaction costs can be broken down into:
- Broker commissions: The fees charged by brokers on every trade a fund makes.
- Bid/offer spread: The buying price of shares exceeds the selling price at any given moment. The difference is the spread, which is a profit mopped up by the market makers who facilitate trading.
- Price impacts: Funds that buy or sell shares in bulk will find the price moves against them as they try to complete the trade. This is because market makers are not obliged to make unlimited trades at their currently offered price and, for example, will hike prices in the face of a large buy order.
- Stamp duty: A 0.5% tax paid when UK funds buy shares. Happily, trackers based abroad don’t pay stamp duty, unless buying UK shares.
How much does PTR cost you?
Transaction costs are not included in a fund’s TER. A more accurate measure of a fund’s costs adds transaction costs on top of the TER.
This table from a Frontier Investment Management Research report shows how much portfolio turnover could be costing you:
As you can see from the table, transaction costs rise in less liquid markets such as emerging markets.
I recently bought a stake in iShares FTSE UK Dividend Plus ETF (IUKD), a volatile beast with value overtones. The TER is 0.4%, but turnover in 2010 was a whopping 241.41%.
According to the figures above, that turnover would have cost me nearly another 4%, or 10 times the TER. And IUKD won’t be as liquid as a large cap fund.
A rough rule of thumb for transaction costs is suggested by William Bernstein in his excellent book The Investor’s Manifesto
0.1% of return is lost for every 10% of turnover.
Bernstein though is writing about the American market, which is more likely to benefit from lower transaction costs due to its higher liquidity.
From the table above, Frontier’s UK estimates imply that:
0.2% of return is lost for every 10% of turnover.
The median UK index fund has a turnover of 13%2, which translates into a hit of around 0.2%. Set next to a TER of 0.27% for cheap FTSE All-Share trackers, that’s a big extra slice off your bottom line.
Where do I find the turnover rate?
PTR’s generally lurk in your fund’s annual report. You’ll be able to find the latest report in the document section of your fund’s website, alongside the factsheet.
PTR’s can vary wildly from year-to-year, and from fund-to-fund, as this snapshot from iShares 2010 Annual Report reveals:
| iShares ETF | PTR |
| MSCI World | 11.39% |
| FTSE 100 | 17.10% |
| FTSE 250 | 70.74% |
| FTSE Dividend Plus | 241.41% |
| Euro Government Bond 1-3 | 298.99% |
Trackers that capture a large part of the market like MSCI World tend to have a low turnover. Bond funds and equity funds that replicate only a portion of the market such as value, mid or small caps are likely to suffer higher turnover, as illustrated by the FTSE 250 and FTSE Dividend Plus ETFs.
Yahoo Finance also carries PTR info for some funds (click on Fund Profile and look for the Annual Holdings Turnover figure), although it can be out of date.
You can also pick up the impact of turnover rates if you check a fund’s tracking difference against its benchmark.
However you do it, just make sure you consider portfolio turnover when choosing trackers, because the TER doesn’t tell you everything you need to know.
Take it steady,
The Accumulator
It’s worth noting that although ETFs that use sampling technique or derivatives have lower turnovers, they expose investors to other risks (deviation from the index, counterparty risk) to be considered.
“iShares FTSE UK Dividend Plus ETF (IUKD), a volatile beast with value overtones. ”
This is an aside from someone who bought into IUKD as a value play and got badly burned. I eventually reached the conclusion that it is systematically a loser. Without any real assessment of value, IUKD buys into high-yielders. A proportion of these are companies on the skids… the market knows they are heading for trouble but dividends have not yet been cut (e.g. banks in mid 2008). Dividend cuts are subsequently announced; the price falls further, and IUKD dumps them on the next quarterly review (this is precisely the time when a contrarian value investor might consider buying).
I bought in 2008 at around £10 with the FTSE at 6000. Now the FTSE is 6000 once again but IUKD is £7.80. Dividends didn’t come close to making good that shortfall.
Rob
1. Hi TA, thanks for another great post.
2. There’s something you haven’t mentioned which I think might be relevant to portfolio turnover for passive funds: the frequency of reviews for a given index. For instance, the FTSE All-Share Index is reviewed quarterly, as you know. Indices differ in the regularity of reviews. Each review might, of course, necessitate buying and selling by the fund manager – and so incur transaction costs.
3. Oh, and another thing. You rightly highlight how a high turnover rate is a drag on fund performance, due to the extra transaction costs involved. However, we mustn’t forget that one purpose of index reviews is: to ensure that an index is an accurate representation of the relevant market. Therefore, a high turnover rate might be required in order to minimise the tracking error between a fund’s performance and that of the index in question. An index review, if it leads to a significant change in the index, forces the fund manager to deal accordingly. Otherwise, the fund is not a tracker. In other words, the stability of an index – its constituents and their weights over time – must surely influence portfolio turnover of a tracker on that index.
@ Rob – thank you for sharing your insights on IUKD. Very interesting. The Investor is a critic of that ETF too and I note that it provokes plenty of debate and derision on The Motley Fool. I have dipped a toe in and we’ll see how that works out. Problem for passive investors is there’s no other tracker with even a whiff of UK value about it.
@ Alex – all fair points. As long as investors are aware of a fund’s turnover rate and what it may cost then they can make an informed decision as to whether that’s worth it. It may be that you can get most of the value out of an index by choosing a broader market version that suffers less turnover.
@Rob – I agree, as TA has kindly mentioned in his response. It may occasionally do well, but it’s a barmy back-tested black box monster as far as I’m concerned.