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1 August 2013 CFA Institute Journal Review

Don’t Just Do Something, Sit There (Digest Summary)

  1. Thomas M. Arnold, CFA

Recent research has demonstrated that mutual fund managers have a tendency to trade too much. This turnover has costs in excess of declared trading costs: Less liquid stocks suffer a detrimental price impact when large amounts of shares are sold at one time. In contrast, experienced individual investors learn to trade less, thus improving their performance.

What’s Inside?

Recent academic research reported in the Financial Analysts Journal (FAJ) and based on a sample of 1,758 U.S. equity mutual funds demonstrates that mutual funds with large positions and frequent turnover tend to underperform. High turnover can have a price impact on less liquid stocks beyond trading costs. Such expenses are undeclared and reduce the performance of the fund. Although excessive trading has been shown to negatively affect performance, mutual fund trading activity has steadily increased.

Curiously, research shows that more experienced individual investors tend to have better returns because they have learned to trade less and to hold positions longer (generally, in value stocks). The author offers a few explanations as to why fund managers appear to behave in the opposite manner. For example, the quick turnover of poorly performing fund managers may necessitate more turnover as the new manager unwinds the previous manager’s positions.

How Is This Article Useful to Practitioners?

According to the FAJ article, a mutual fund investor can measure a fund’s “position-adjusted turnover.” A fund’s average holding size is compared with the average holding size of other funds in the same category (e.g., small cap), and the turnover of the funds is then compared. This measure allows the investor to determine whether a fund’s activity follows a strategy that often results in underperformance (i.e., large positions with high turnover).

For the individual investor, the lesson that the author provides is simply one of patience with regard to holding positions and the benefit of a longer-term outlook.

Abstractor’s Viewpoint

Measuring holding size and turnover as a way to determine a manager’s “hyperactivity” is an appealing approach to avoid poorer performing mutual funds. Hyperactivity, as stated in the article, could be a result of behavioral factors or of the frequent turnover of poorly performing managers (i.e., a structural factor). Regardless of its cause, excessive trading affects mutual fund performance; position-adjusted turnover is a metric worthy of consideration by investors when selecting mutual fund investments.

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