Category Archives: Investing

Fund Turnover Ratio Can Cost You Money

Cut-costs-with-low-turnoverSomething that isn’t often discussed about mutual funds is their turnover ratio. The turnover ratio is “the percentage of a mutual fund or other investment vehicle’s holdings that have been ‘turned over’ or replaced with other holdings in a given year” —Investopedia. A 100% turnover implies that the fund’s assets are completely sold and replaced every year. A 200% turnover implies that the fund’s assets are replaced every 6 months.

In general, actively managed mutual funds have a much higher turnover ratio than passively managed index mutual funds as the active managers trade stocks in an effort to beat their respective index. From Vanguard,

Turnover, or the buying and selling of securities within a fund, results in transaction costs such as commissions, bid-ask spreads, and opportunity cost. These costs, which are incurred by every fund, are not spelled out for investors but do detract from net returns. For example, a mutual fund with abnormally high turnover would be likely to incur large trading costs. All else equal, the impact of these costs would reduce total returns realized by the investors in the fund.

And from Investopedia, “A fund’s trading activity, the buying and selling of portfolio securities, is not included in the calculation of the expense ratio.” So we need to look elsewhere for how much turnover may cost.

Stefan Sharkansky published a study in 2002 titled, “Mutual Fund Costs: Risks Without Reward,” that looked at the impact of fees in the form of expense ratios, transaction costs in the form of turnover ratios, and taxes. (Note that “bps” stands for basis points. A basis point is 1/100 of a percent.)

We find a consistent negative relationship between fund turnover and performance in every category of fund that we examined. In Larger-Cap U.S. equity funds, we observed that on average, each 100% of turnover was expected to reduce the fund’s average annual pre-tax return by 124 bps (1.24%). Similarly, each 100% of turnover was shown to reduce the expected annual return by 255 bps for Smaller-Cap U.S. funds, 154 bps for International Equity funds, 43 bps for Municipal Bond funds and 9 bps for U.S. Government Bond funds. There results are within the range of other studies that have examined the costs of institutional trading and the relationship between fund turnover and performance.

Thus, we see that turnover costs are a hidden cost that investors need to be aware of. According to Morningstar, “It’s not uncommon to see turnover rates of 300% or more, even in funds that aren’t particularly aggressive.” This would mean an annual loss of at  least 3.72% for funds with a 300% turnover ratio. And that’s before taxes.

300% seems high to me, but 100% turnover is very common for actively managed funds. 1.24% in turnover costs is still a huge amount for a fund to overcome just to pull even with a comparable low-cost index fund. And that does not even take into account the 1% or more in fees that most active mutual funds charge. This would put costs for an actively managed fund with 100% annual turnover at roughly 2.2% or more. Ouch.

If these funds with high turnover are held in a taxable account, much of their turnover will be realized as short-term capital gains, especially if the turnover ratio is higher than 100%. That means you could be paying capital gains taxes at your marginal income tax rate for stock sales in the mutual fund for which you never received any income.

Note that the turnover ratio for Vanguard’s Total Stock Market mutual fund is 4%, which according to Sharkansky would reduce earnings by 5 bps. Add the fund’s expense ratio of 0.05% to get a total annual cost of 0.1%, and it is apparent that low-cost passive index funds can easily beat comparable actively managed funds. Especially if you are investing in a taxable account where the added taxes due to high turnover make it almost impossible for the active funds to beat low-cost index funds.

Do you hold actively managed funds? If so, do you know what their turnover ratio is, and how much that may be costing you?

Get the Best Performance From Your Portfolio

don't touchThe Market has fallen from its high! There has been widespread selling over the past few days! The Fed may raise interest rates soon! September was a down month! What should I do as an investor? The answer for most people is to do nothing.

In an August 30, 2014 Masters of Business podcast from bloomberg.com, Barry Ritholtz talked with James O’Shaughnessy of O’Shaughnessy Asset Management about how people often mess up their investments.

O’Shaughnessy talked about a Fidelity study that found that the accounts that had done the best were the accounts of people who forgot they had an account at Fidelity. He said it comes down to our behavioral biases, where we are apt to buy high and sell low.

Ritholtz told how families fighting over inherited assets might not be able to touch these assets for something like 10 or 20 years while they worked out their disagreements. Of course they later found that those 10 or 20 years of untouched assets gave them better performance than their closely watched portfolios.

I wrote about this over a year ago when I discussed how often a person should look at their portfolio. My conclusion was that it’s OK to look as long as you don’t touch. Rebalancing once a year is enough to make sure your investment risks are where you want them to be.

I posted a link in that article to an interview with John Bogle, the founder of Vanguard, who likened investing to visiting a casino. He said, “You go into the casino. You buy every stock in the casino. And then get the heck out and never darken its doors again. Don’t trade. Don’t do anything.” This is sort of a colorful way of saying that people should invest with index funds, and once purchased, leave them alone. He also said, “Owning all the companies in America, and holding them forever is, and will be, and must be, the winning strategy.”


Are you nervous about the market? Have you thought about selling?

Investment Policy Statement

Our IPSI was at a friend’s house last week when he asked if I was planning to sell any stocks since the market is hitting new highs. I told him that my asset allocation has become a bit biased toward equities, due to the recent market gains, but I won’t do any asset rebalancing until the proper time of the year, as spelled out in my investment policy statement (IPS). I told him I wanted to wait at least a year between rebalancing so that I will only incur long term capital gains if I need to sell stocks in my wife’s and my joint taxable account (which is what we will probably need to do).

I also told him that I quit trying to time the market a long time ago, and am much happier for it. We max our retirement accounts with appropriate monthly contributions, and then push additional money into our taxable investments. Each month, we invest this extra money in the under-weighted part of our asset allocation. And that it’s all spelled out in our IPS.

My friend then asked why I thought I needed an investment policy statement. He also admitted that he did not really know what an IPS was.

I told him that an IPS is a written statement that “defines general investment goals and objectives. It describes the strategies that will be used to meet these objectives and contains specific information on subjects such as asset allocation, risk tolerance, and liquidity requirements.” The part in quotes is directly from the Bogleheads.org wiki.

The benefits of using an IPS are that “it provides the foundation for all future investment decisions to be made by an investor. It serves as a guidepost, identifies goals and creates a systematic review process. The IPS is intended to keep investors focused on their objectives during short-term swings in the market and provides a baseline from which to monitor investment performance of the overall portfolio. Someone who doesn’t have a written policy often bases decisions on day-to-day events, which often leads to chasing short-term performance that may hinder them in reaching long-term goals. Having a policy encourages maintaining focus on the long-term nature of the investment process, especially during turbulent or exuberant times.”

I happened to have my laptop with me, so I pulled up my IPS to show my friend.

Investment Policy Statement

Philosophy

The Portfolio consists of all family joint investable assets as well as individual retirement assets.

Our investment philosophy is based on the Boglehead philosophy

  1. Develop a workable plan
  2. Invest early and often
  3. Never bear too much or too little risk
  4. Never try to time the market
  5. Use index funds when possible
  6. Keep costs low
  7. Diversify
  8. Minimize taxes
  9. Keep it simple
  10. Stay the course

Strategy

Desired asset allocation (AA) is roughly 50% percent in bonds plus cash, with remaining 50% in equities. The AA is based on Fama-French Trinity Study in which they use a 50/50 AA as the optimum ratio for a safe withdrawal rate of 4% with inflation adjustments over a 30 year span. This is also a good moderate AA in the latter stages of accumulation (prior to retirement).

Taxable bonds should be held in tax advantaged accounts with 50% total bond market, 50% inflation protected (That includes TIPs and I-bonds). Note that I-bonds and tax-free muni bonds must be held in taxable accounts.

Equities are approximately 85% US, and 15% international. US holdings are split among total stock market (TSM) and small-cap value (SV) stocks, with other small additions, such as REITs. (Tax-inefficient REITs, like taxable bonds, should be held in tax advantaged accounts.) SV are roughly 30% of total US equities.

Discipline

The asset allocation is checked once a year on Bryce’s birthday. Rebalancing of assets to 50/50 will be done if the asset balance is 10% or more off (i.e., if the AA has changed to 60+/40- due to appreciation of equities, equities will be sold and bonds will be bought to get back to 50/50).

No matter the current AA, $20,000 in taxable savings should be set aside to purchase i-bonds at the April-May timeframe of each year. Previous year-end dividends and savings should be used. A high-interest savings account will be used to hold money earmarked for next year’s i-bond purchase. The expectation of the $20k i-bond purchase may be used to offset out-of-band AA on Bryce’s birthday, assuming $20k in bonds will make a difference.

New assets will be applied to either equities or bonds depending on which asset is currently low in the 50/50 AA. This will help to maintain the AA without having to sell any assets.

The AA will be maintained when there is a need for money. The asset class that is “high” in the AA will be sold first. Assets will not be bought or sold based on market movements. Cash may be used, even if it is in the low asset class, assuming it will be quickly replaced by monthly savings.

That is our IPS. It is pretty simple, yet it helps us to stay the course and keep emotions in check as the market goes through its typical gyrations. There are more and better examples of IPSs in the bogleheads’ wiki.

Expense Ratio That’s Too High to Own

A while back I wrote a post that highlighted how seemingly insignificant fees can take away a lot of your total portfolio when these fees are compounded over many years.

cumulative-impact-of-fees

Recently, someone on bogleheads.org asked how high of an expense ratio (ER) is too high.

Do you set benchmarks? For instance, over 0.5% is too high? I’ve seen Target retirement funds offered by company’s 401k in the ~0.7%+ range and see individual index funds around ~0.2%. Is this enough of a difference where you prefer investing in the individual funds?

Any personal experience of why one is better than the other?

Where do you guys see yourself backing out of funds in terms of ER? Where do you set the tipping point where convenience is better than ER and vice versa?

One answer that I really like and agree with came early in the thread,

I target .1% in total fees. .7% is huge, compounded over decades. I’d certainly use individual funds in that case, or even alter my asset allocation to get a cheaper fund.

The weighted ER for all funds that my wife and I own is 0.11% It would be lower except that our 401(k) stable value fund has an ER of 0.5%. Another boglehead answer puts some qualitative assessments on some ER ranges,

<=0.10%: My favorite!
0.11-0.20%: Acceptable
0.21-0.40%: Getting Expensive
0.41-0.50%: Better be special
>0.50%: No thanks

Or, if you were to put it in dollars taken from your account in fees over one year (say you had $500k)

<=$500: My favorite!
$550 – $1,000: Acceptable
$1,050 – $2,000%: Getting Expensive
$2,050 – $2,500 : Better be special
>$2,500: No thanks

Someone who is willing to pay a little more said,

Depends on type… If it’s an S&P500 idx or alike better be < .1 but if it’s – say – an international small cap value or something I would accept far higher expenses….. A lot here might disagree on holding such a fund at any price or the “max” they would be willing to pay.

And then, finally, my favorite answer,

This pretty much sums it up. I would love to have all my ERs at .05. But I am going to pay .12% to get my bond fund. I am going to pay .15% for Emerging Markets and so on. ER is not the driver of my investing strategy. I figure out what I want and then figure out how to get it as cheaply as possible.

Do you know what your total weighted ER is for your entire portfolio? Morningstar’s portfolio x-ray will automatically give your weighted ER after you have entered each fund or ETF and the number of shares you own. You can get it for free at T. Rowe Price.

Asset Location in Various Accounts

asset-allocationLast July, I wrote Asset Allocation Across Multiple Accounts, an article discussing what type of asset (stocks, bonds, REITs, etc.) should be stored in what type of account (taxable or tax sheltered).

Tax efficiency is the main reason to treat all accounts as one large account. You want to have tax inefficient holdings, like REITs and taxable bonds in your tax sheltered accounts, such as your 401(k) and IRAs, and tax efficient holdings, like the Total Stock Market index fund, in your taxable investment account.

I generated a table showing the least tax efficient asset classes to the most tax efficient asset classes with corresponding types of accounts that they should be held in. I have reproduced the table, below.

Least tax efficient High-yield bonds Best held in tax-sheltered accounts
High-turnover active stock funds
REITs
Active stock funds
Taxable bond funds
Target-date funds (contain both stocks and bonds)
Cash Can be held in either taxable or tax-sheltered accounts
Value index funds
Small or mid-cap index funds
Total international index funds
Total US market index funds
Most tax efficient Tax-managed funds

The reason I am looking at this again, is that Rick Ferri recently wrote an article asking, “Does Asset Location Make Sense?”

Rick wrote,

This strategy sounds correct on the surface and it’s often heralded in the media as a smart way to invest. I agree with the concept in general, but that doesn’t mean there aren’t drawbacks. Here are some of the problems I see with asset location for tax purposes:

  1. Tax-favored account capacity: you may not have enough room in your non-taxable or tax-deferred accounts to accommodate enough bonds to have the overall asset allocation that you desire.
  2. Taxable account capacity: the same limited capacity issue may occur in your taxable accounts and the amount of stocks you wish to own.
  3. The choice may not be yours: your employer-sponsored 401(k) may have poor bond choices and good stock fund choices, or there may not be any REITs available.
  4. Accounting across accounts: maintaining a portfolio to a target asset allocation becomes more difficult when you’re monitoring an allocation “across” several accounts rather the same allocation “among” accounts.
  5. Rebalancing across accounts: rebalancing a portfolio becomes more difficult when several adjustments need to be made across different account types. Settlement dates may be different, or you may be restricted on when you can trade one account versus another.
  6. Tax rates in the future cannot be known: the tax strategies we employ today tend to be focused on the situation today rather than in the future. A tax-saving strategy today might cost more in taxes than anticipated as your tax rates changes in the future.
  7. Liquidity becomes expensive: your situation is bound to change over the years as your life changes. There may be a time you need liquidity to buy a home or for another purpose and you find yourself selling the only thing you have in your personal account are stocks. This could mean paying a lot in capital gains taxes when you need the most liquidity.

The alternative to an asset location strategy “across” accounts is to hold the same asset allocation “among” accounts. Assuming you have one taxable and one non-taxable account of the same value, you would hold the same asset allocation in both accounts.

He goes on to argue that perhaps people ought to do both strategies: divide some asset classes into different accounts based on tax efficiency, and also put some of the same asset classes into all accounts.

My concern with putting the same mix of asset classes in each account you own is that you will pay more taxes during asset accumulation, and not have as much money in retirement.

I think Rick’s concern, which he mentioned above, is that using a location-based strategy is too complicated for most people. Putting the same asset class mix in each account is certainly easier. Doing a mix of both strategies, however, is more complicated than either strategy by itself.

Personally, my wife and I will stay the course with a location-based strategy. I also know of several people who are more happy having the same asset allocation in each account, even though it is less tax efficient. I doubt, however, that many people will follow Rick Ferri’s advice to combine the strategies across all accounts.