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Cut costs with low turnover trackers

Cutting costs is the name of the game for passive investors [1], so watch out for the effect of Portfolio Turnover Rate (PTR) on your trackers.

For all the focus on Total Expense Ratios [2] (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 [3] your fund’s exposure to stealth costs like:

These costs aren’t high on many investor’s radars, but they will together knock a chunk off your return.

Leave no stone unturned in your search for hidden costs. [4]

What is turnover?

The portfolio turnover rate [5] measures how often a fund’s securities are bought and sold within a 12-month period.

For example, a PTR of:

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:

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 [7] shows how much portfolio turnover could be costing you:

How much turnover costs you [8]

As you can see from the table, transaction costs rise in less liquid markets such as emerging markets [9].

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 [10]:

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 [11], 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 [12] 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 [13] 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

  1. Portend [18]. Verb. To indicate in advance; to foreshadow or presage, as an omen does. For example: The street incident may portend a general uprising [ [19]]
  2. Frontier Investment Management Research [ [20]]