Portfolio turnover white paper

FOR INSTITUTIONAL USE ONLY/NOT FOR PUBLIC USE

Portfolio Turnover: It’s Not As Important As You May Think

By Kevin Lewis, CFA, Vice President, Client Portfolio Manager

Investment Viewpoints

Kevin Lewis, CFAVice President Client Portfolio Manager

Kevin is Client Portfolio Manager for the Growth Equity Investment Discipline at American Century Investments. Prior to his current role, he was a portfolio manager for two domestic growth strategies at American Century Investment Management. Before joining the firm in 1995, Kevin was a senior equity portfolio manager at Virtus Capital Management and has worked in the investment industry since 1983. Kevin earned a bachelor’s degree in business from Virginia Tech. He is a CFA charterholder and a member of the CFA Institute.

FOR INSTITUTIONAL USE ONLY/NOT FOR PUBLIC USE 2

Several recent academic research papers have rejected the widely-held notion that portfolio turnover has a negative impact on investment performance. Some of the reasons given for this contradictory assertion include the facts that: •portfolioturnoverisnotagoodproxyfortradingcosts • tradingcostshavedeclinedovertimeduetoimprovementsintradingtechnologycombinedwith the rise of alternative trading markets • therearedeficienciesinthecalculationofthe“portfolioturnover”statisticitself. Theirfinalconclusion,andonethatwewereabletocorroboratewithourownindependent briefstudy,isthatadvisorsandconsultantsshouldutilizeotherstatisticstoevaluateinvestmentmanagersbecausehigherportfolioturnoverisnotcorrelatedwithlowerinvestmentreturns.

The portfolio turnover and performance debate High portfolio turnover has long been considered a drag on investment returns. Academic studies dating back fifteen years provided evidence that this relationship once existed. In those studies, higher turnover had a negative correlation with returns. In particular, an article in a 1993 issue of The Review of Financial Studies by E. Elton, M. Gruber, S. Das and M. Hlavka notes that historical performance was negatively correlated with portfolio turnover.

But more recent academic studies have arrived at different—and conflicting—conclusions. Between 2000 and 2001, four new academic studies on the subject were published. Two (Russ Wermers in a 2000 Journal of Finance article, and John Chalmers, Roger Edelen and Gregory Kadlec in a 2001 University of Pennsylvania Wharton Working Paper) concluded that there was no broad statistical relationship between turnover and investment returns. They contended that the turnover and return relationship varied considerably depending on the market capitalization and investment style of portfolios being considered. For example, large-cap growth portfolios had substantially different correlations of turnover and returns than those for small-cap value portfolios.

Meanwhile, two other papers concluded that portfolio turnover is positively correlated with investment performance. The idea behind these papers was to try to distinguish between turnover based on information content, that is, “informed turnover,” seeking opportunities to generate alpha, versus “uninformed turnover,” based on other motivations such as investment flows, risk management requirements and ex-post reactions to sudden changes in security values.

Most recently, a March 2007 paper titled Scale Effects in Mutual Fund Performance: The Role of Trading Costs1 was posted for peer review, and generated substantial interest both in academic and industry circles. The paper described an eleven-year analysis of mutual fund returns and confirmed that portfolio turnover is not generally harmful to fund returns. This conclusion rested on the observation that the components of trading costs vary substantially based on the size and style of the portfolio and trade motives.



The 2007 Study The March 2007 paper describes a comprehensive study that directly estimated the trading costs of 1,706 open-ended mutual funds of all size/style categories from 1995 to 2005. Morningstar supported the research by providing access to its databases, allowing researchers to track quarterly trades for every security held by each mutual fund in the study universe over an eleven-year timeframe. Dr. Gregory Kadlec, one of the authors and professor of finance at Virginia Tech, presented the paper at the June 2007 Morningstar Investors Conference.

The authors’ motive for this study was the growing recognition that portfolio turnover does not necessarily result in higher trading costs. To back this assertion, they cite the conflicting conclusions of past studies and make the following points:

• Turnover is a poor proxy for determining actual fund trading costs because unit trading costs vary dramatically across size/style categories of securities. Referencing a 2004 industry study that estimated per-unit trading costs for large-cap value stocks at 32 basis points (bps) and for small-cap growth stocks at 132 bps, they observe that a large-cap value portfolio with 150% turnover will have lower annual trading costs than a small-cap growth portfolio with 50% turnover.

• Because turnover is reported as a percentage of average assets instead of absolute dollar volume, it fails to capture differences in trading costs arising from differences in trade size. The authors reference both theoretical and empirical studies that find trade size is an important determinant of trading costs.

• Turnover does not capture all of a portfolio’s trading activity. Defined as the minimum of security purchase or sales divided by average fund assets for a given period, turnover statistics can be misleading. For example, a portfolio with purchases of 100% of average assets and sales of 20% will have lower reported turnover than another portfolio with purchases and sales both equal to 25% of average assets.

Given these limitations of turnover, the authors note that it’s not surprising that the conclusions of past studies on turnover and returns have been mixed.

They defined an analytical model to bypass turnover and directly estimate portfolio trading costs:

Trading Costs = Trading Volume x Per Unit Trading Costs

where trading volume equals the size of each trade, and per unit trading costs reflect commissions paid, the bid-ask spread of the trade and the price impact of each trade. The former two factors— commissions and the bid-ask spread— reflect prior insights that the ‘cost of turnover’ varies substantially based on the style/style of shares traded. The latter factor— the price impact of trading— reflects the prior insight that trade motive has a significant impact on trading cost. The paper concludes that all of these factors in combination define a statistical relationship with portfolio returns that turnover fails to capture.


Portfolio turnover impact in the recent environments Given the market environment in the latter part of 2007 and first half of 2008, we wanted to see if the newer academic research findings persisted, particularly since this period was noted for its substantial market volatility and uncertainty. Our team reviewed the reported mutual fund turn-over and returns based on the Morningstar size/style matrix for the twelve month period ending June 30th, 2008. The analysis included 2,529 open-ended U.S. mutual funds and compared turnover versus returns for each of the nine size/style categories. Our objective was to determine if we could detect a statistical relationship between the turnover and returns in this volatile environment. (See Appendix for more detail on the methodology used in our study).

Extreme values— however unusual— can skew regression analysis. So we also ran our regression excluding the highest decile of turnover in each of the nine size/style categories. The graphs below illustrate the regression results for large-cap growth portfolios for the period from July 1, 2007 to June 30, 2008. Notice in both graphs that the regression line slope is slightly positive, indicating weak positive relationship between turnover and subsequent performance.

Similar regressions were run for the other eight size/style fund categories. The size/style matrix on the next page summarizes our review. We found that there was no relationship between the two variables in the majority of the categories. The large cap growth category showed a weak positive statistical correlation between turnover and returns. And the mid cap growth catagory showed a weak negative statistical correlation which reversed to a weak positive correlation when funds in the top decile of turnover were eliminated. Therefore the data from this more-volatile-than-average one-year period did not appear to deviate from longer-term academic research findings. That is, portfolio turnover in the recent environment continued to be a poor predictor of portfolio trading costs and investment performance.

Large Cap Growth: 1 Yr Fund Returns vs. TurnoverAll Funds Included

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Fund Annual Turnover (%)

1 Year Fund Returns

Large Cap Growth: 1 Year Returns vs. Portfolio Turnover(All Deciles of Fund Turnover Included)

July 1, 2007 to June 30, 2008

Large Cap Growth: 1 Year Returns vs. Portfolio Turnover(Highest Decile of Fund Turnover Excluded)

July 1, 2007 to June 30, 2008

Portfolio Annual Turnover (%) Portfolio Annual Turnover (%)

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Source: Morningstar and American Century Investments

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Large Cap Growth: 1 Yr Fund Returns vs. TurnoverHighest Decile of Fund Turnover Excluded

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Study Summary: Turnover vs. Returns

Value Core Growth

No relationship between portfolio turnover and performance


Weak positive relationship between portfolio turnover and returns.



Weak negative relationship* (all deciles of turnover) or weak positive relationship (top deile of turnover excluded) between turnover and returns




* Due to Outlier Issues in Highest Turnover Decile of Funds Source: Morningstar and American Century Investments

Implications for investment professionals In assessing portfolio manager performance, turnover is a poor indicator of actual fund trading costs that can hurt investment returns. Recent academic research, as well as our own study, reject the long-standing belief that higher fund turnover usually results in lower returns.

Using turnover as a proxy for trading costs in evaluating asset managers is like using height alone to judge the skill and athleticism of basketball players. Financial professionals shouldn’t be automati-cally biased toward “low turnover mangers”. Instead, they should judge whether the manager’s investment process improves the odds for excess returns.

Bear in mind that discretionary trading motivated by information and portfolio manager skill has lower trading costs than large asset flow-driven trades. Investors should be able to count on a manager to make beneficial trades based on his experience and current information.

And remember that a firm’s trading desk can be an important contributor to portfolio performance (and a competitive advantage) through smart execution that minimizes the cost components of a trade. The past decade has seen vast improvements in trading technology as new alternative trading markets (e.g. ECNs) have been created. These have helped lower trading costs for many managers.

In summary, portfolio turnover has been shown to be unrelated with performance. Using it to screen for asset managers could lead to the elimination of those with the potential to produce excess returns. Therefore, consultants and advisors should use other screening criteria to judge a manager’s investment process and ability to produce excess returns.

Please contact your American Century Investments representative with questions or comments.

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Appendix

I: Past Research on the Effects of Turnover on Fund Performance

Study Authors/Journal Year Conclusions

Elton, Gruber, Das and Hlavka Journal of Financial Studies

1993 Fund returns are negatively related to turnover

Carhart Journal of Finance

1997 Fund returns are negatively correlated to turnover

Dahlquist, Engstrom and Soderlind Journal of Financial and Quantitative Analysis

2000 Fund returns are positively related to turnover

Wermers Journal of Finance

2000 No relationship between fund returns and turnover

Chalmers, Edelen, Kadlec UPenn Wharton White Paper

2001 No relationship between fund returns and turnover

Chen, Jagadeesh and Wermers Journal of Financial and Quantitative Analysis

2001 Fund returns are positively related to turnover

Table Source: Evans, Edelen and Kadlec March 2007 paper

II: Our Study Methodology for Comparing Turnover and Fund Performance We undertook a statistical analysis of reported mutual fund turnover and returns based on the Morningstar size/style matrix using one year data from July 1st, 2007 to June 30th, 2008. The analysis included 2,529 open-ended U.S. mutual funds. We regressed fund turnover versus returns for each of the nine size/style categories to determine if we could detect a relationship.

The fund turnover data for our study universe ranged from under 5% per year to over 4,000%. Extreme values— however unusual— can skew regression analysis in a phenomenon called the ‘outlier effect’. So we elected to run our regressions twice: Once with the full range of funds and turnover, and a second time excluding funds that comprised the highest decile of turnover in each of the nine size/style categories. The figures below illustrate the regression results for mid cap growth funds in both cases:

Large Cap Growth: 1 Year Fund Returns vs. Turnover

(All Deciles of Fund Turnover Included)

April 1, 2007 to March 31, 2008

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Large Cap Growth: 1 Year Fund Returns vs. Turnover

(Highest Decile of Fund Turnover Excluded)

April 1, 2007 to March 31, 2008

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Mid Cap Growth: 1 Year Returns vs. Portfolio Turnover(All Deciles of Fund Turnover Included)

July 1, 2007 to June 30, 2008

Mid Cap Growth: 1 Year Returns vs. Portfolio Turnover(Highest Decile of Fund Turnover Excluded)

July 1, 2007 to June 30, 2008

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Mid Cap Growth: 1 Yr Fund Returns vs. TurnoverAll Funds Included

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Portfolio Annual Turnover (%)

Mid Cap Growth: 1 Yr Fund Returns vs. TurnoverHighest Decile of Fund Turnover Excluded

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In the left hand chart, a total of 282 mid cap growth funds covering the full range of reported turnover were included. Note the outlier effect mentioned earlier due to one fund with nearly 1,350% annual turnover—DireXion Spectrum Equity Opportunity (SFEOX). In the right hand chart, funds within the highest decile of turnover (29 total) were excluded, bringing the turnover range down to more realistic values with a maximum of 200% per year.

This kind of paired regression was run for all of the other eight size/style fund categories. Our basic statistical test involved a null hypothesis that stated “There is no significant relationship between fund turnover and returns”. Using statistical tests of significance, we calculated the ‘risk’ of being wrong if we rejected this null hypothesis and concluded instead that a relationship did exist. Statisticians call this alpha risk and use a metric called the ‘p-Value’ to quantify it.

A very low p-Value (under 5%) is a common threshold used to justify rejecting the null hypothesis. And in those cases where our analysis led us to do so (concluding a relationship between fund turnover and returns did exist) we calculated two other statistics: The slope of the regression line to determine the direction and sensitivity of the relationship between turnover and returns; and the R-squared (R2) which defines how much of the total variation in fund returns is explained by the variation in turnover.

The size/style matrix below summarizes our findings. It was only with mid cap growth funds in-cluding the top decile of turnover that we could statistically establish a weak relationship for the ‘accepted wisdom’ that higher fund turnover results in lower returns. However the strength of this negative relationship reversed and became a positive relationship with the highest decile excluded (29 funds with average turnover of 381% per year).

A final finding was that, in those cases where we could statistically establish a relationship between fund turnover and returns (positive or negative), the R2 of the relationship (or the explanatory power of variations in turnover to account for variations in returns) was very low.

Study Summary Statistics by Size/Style Category

Note: Slope is expressed as basis points of return for each additional 1% increase in fund turnover

Value Core Growth

All Deciles Ex Top Decile All Deciles Ex Top Decile All Deciles Ex Top Decile

p-Value 62.0% 53.0% 62.0% 55.0% 1.9% 8.0%

R2 0.4% 0.0% 1.0% 0.6% 0.1% 1.6%

Slope 0.8 -0.2 0.5 1.2 0.1 2.0

p-Value 7.4% 3.0% 18.0% 16.0% 1.6% 1.0%

R2 0.1% 0.0% 0.1% 0.0% 0.2% 4.9%

Slope 0.3 0.0 0.1 0.0 -0.2 3.5

p-Value 17.1% 26.0% 1.7% 27.0% 94.0% 90.0%

R2 1.9% 0.4% 2.1% 3.3% 0.0% 0.1%

Slope -0.8 -1.4 -0.9 -3.5 0.1 0.7

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FOR INSTITUTIONAL USE ONLY/NOT FOR PUBLIC USE

Endnotes1Scale Effects in Mutual Fund Performance: The Role of Trading Costs; Edelen, R.; Evans, R; and Kadlec, G; March 17, 2007. See the following link at the Social Sciences Research Network (SSRN) website to download a PDF copy of this paper (http://ssrn.com/abstract=951367 ).

August 2008

Past performance is no guarantee of future results.

Statements represent personal views and compensation has not been received in connection with such views. This information is not intended to serve as investment advice.

The opinions expressed are those of Kevin Lewis, CFA and are no guarantee of the future performance of any American Century portfolio.

For educational use only. This information is not intended to serve as investment advice

Data source for historical mutual fund returns and turnover: Morningstar

Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. All funds listed and analyzed are open-ended mutual funds. Features of the funds may differ, including, but not limited to, sales and management fees, liquidity, safety, guarantees, insurance, fluctuation of principal and/or return, tax features and other characteristics not covered in this material. Past performance is no guarantee of future results.

You should consider a fund’s investment objectives, risk, charges and expenses carefully before you invest.

P.O. Box 419385Kansas City, MO 64141-63851-800-345-6488www.americancentury.com/ipro

American Century Investment Services, Inc., Distributor ©2008 American Century Proprietary Holdings Inc. All rights reserved.

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Portfolio turnover white paper

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