Portfolio Turnover - The Hidden Cost of Active Management

The activities undertaken by an active fund manager normally result in higher annual management charges. This is what you would expect as they must carry out more research and analysis than a passive "manager". However, what few clients fail to appreciate is, the buying and selling of shares within a fund also incurs costs and these subsequently impact detrimentally on performance.

This is known as the "performance drag".

A Financial Services Authority (FSA) report* authored by Kevin James undertook to quantify the costs of trading to determine the performance drag. He concluded that the cost of a "round trip" trade in the UK was 1.8%. A "round trip" is the selling of one company's shares and replacing them with another for the same value. For example selling 10,000 worth of Barclays' shares and replacing them by buying 10,000 worth of HSBC shares.

Let's look at a breakdown of the costs:

- Commission 0.3%

- Bid/Offer Spread 0.75%

- Price Impact 0.25%

- Stamp Duty 0.5%

Major studies elsewhere in the world have concluded similar results**. The headline figures were lower but they did not include Stamp Duty as Stamp Duty is only payable on UK shares.

A Government commissioned report into retail investments by Paul Myners estimates that portfolio turnover costs UK investors 2.5 billion each year. The UK has only recently fallen into step with the rest of the world in making it compulsory for fund managers to disclose their portfolio turnover. This revealed that many of the best selling UK funds have portfolio turnover rates of between 100% and 200%.

If the portfolio turnover rate of a UK fund was 100% this would "cost" the client 1.8% in Performance Drag.

The impact of charges has never been more important in arranging an investment portfolio. If the explicit annual fund management charges are 2% and the implicit costs of portfolio turnover is a further 2% then this means 4% is being wasted in charges. Charges of this level were masked by the double digit returns of the eighties and nineties but as the stockmarket returns to its long term average, losing 4% per annum will have a significant impact on the actual returns clients receive.

In addition, studies in the US*** concluded that the higher charges associated with portfolio turnover were not recovered by better performance.

*Financial Services Authority (FSA) Occasional Paper 6
**Wilcox (1993) 1.2%, Carhart (1997) 0.95%, Orton (1999) 1%, James (2000) 1.3%
***Performance of Mutual Funds, J Chalmers, R Edelen & G Kadlec Nov 1999

The Financial Tips Bottom Line

As you are probably not aware what the turnover rate is on your investment funds, the easy reaction could be to simply ignore it.

The good news is that the information IS available, and you can get hold of it by contacting your fund provider(s) and asking them. The details are normally contained in their fund prospectus.

You'll then be able to see the additional costs levied, which will help you decide how to invest your money in the future.