Equity portfolios’ tell-tale turnover

Asset owners need to be more aware of the turnover in their equity managers’ portfolios, as it not only hides costs, but also acts as a proxy for the short- or long-term behaviour of managers.

A research paper produced by the 2° Investing Initiative, the Generation Foundation and Mercer analysed more than 3500 institutional long-only active equity funds in Mercer’s global investment database.

The analysis showed the equity fund managers replace all of the names in their portfolio every two years, on average. That equates to a share replacement rate of 1.7 years.

While optimal turnover for investment performance is not a well-defined concept, the report states, a review of literature on the subject points to a four-year holding period (25 per cent turnover) as a reasonable estimate of what’s optimal. That is well below the average turnover rate identified in this analysis, which is 58 per cent.

The report did show that turnover has declined over time, but only gradually.

“The decrease in turnover suggests increasing demand for longer-term investments from asset owners,” the report states. “There remains more room for turnover levels to fall among long-only active equity managers, before reaching equilibrium.”

‘Tragedy of the Horizon’

The 2° Investing Initiative and the Generation Foundation have formed a multi-year partnership to explore and address the “Tragedy of the Horizon”, which they describe as the “potential sub-optimal allocation of capital for the long term due to the limited ability of the finance sector to capture long-term risks within short-term risk-assessment frameworks”.

Their project aims to assess artificial and natural factors that compress the horizons of market players, such that long-term risks get mispriced. Such a mispricing of long-term risks creates a void between the assets and liabilities of long-term asset owners and can eventually amount to an asset-liability mismatch.

Their report, The long and winding road: How long-only equity managers turn over their portfolios every 1.7 years, looks at the impact of turnover on long-term investing. Mercer provided data and analysis.

“High portfolio turnover makes the investors’ decision-making process full of twists and turns, obstructing their view of long-term performance and an optimal allocation of capital for the long term,” the report states. “Giving investors a straighter road, or [having them] hold assets longer, may make them more efficient drivers and better fiduciaries in the long term.”

The paper focuses on the role turnover plays in the asset owner-asset manager relationship and how a deeper understanding of this particular variable during fund evaluation can help investors. Findings show that turnover is going down in professionally managed long-only equity funds, on average, despite rising overall sharemarket turnover. Most equity managers appear to do a good job of keeping actual turnover within or near initial expected levels, the report states.

Other findings were that quantitative strategies, on average, exhibit higher turnover than fundamental and blended strategies; and there are cases where managers seem to make suboptimal decisions due to their belief that clients could not tolerate short-term volatility. Also, managers commonly view the turnover ratio as an outcome of their process, not an input or end they pursue.

Encourage optimal behaviour

The report has some clear messages for asset owners. In particular, they should improve how they monitor and communicate with investment managers if they wish to encourage optimal behaviour.

Asset owners should:

Be explicit about their time horizon and expectations for how it will affect asset-class exposures and the types of investment managers and strategies they’ll employ. This could include a behavioural policy statement, for example, incorporated as an appendix to the statement of investment beliefs document; ideally, the beliefs would establish a clear set of actions that specify how the asset owner would be expected to react to short- and medium-term manager underperformance

Avoid making short-term decisions by designing a reporting framework for monitoring managers that looks beyond short-term price performance

Develop and promote a process to check manager behaviour against expectations; this may include looking at areas such as portfolio characteristics, level of portfolio turnover and drivers of portfolio activity

Compare actual performance against the hypothetical buy-and-hold performance of the portfolio over a given period, to assess the benefit of portfolio turnover

Ask for more detail regarding frictional transaction costs managers incur and develop a process to check manager behaviour against initial expectations

Be explicit about managers’ time horizons and how they expect it to affect their decision-making, the design of employee compensation and incentives, and expectations for how they will interact with clients

Include greater discussion of turnover and management of transaction costs in the ongoing management of the portfolio.