In the article, “The Pre-Tax Costs of Portfolio Turnover” by David Blanchett dated May/June 2007 there is important discussion of the topic of portfolio turnover. Investopedia.com defines portfolio turnover as:
“A measure of how frequently assets within a fund are bought and sold by the managers. Portfolio turnover is calculated by taking either the total amount of new securities purchased or the amount of securities sold - whichever is less - over a particular period, divided by the total net asset value (NAV) of the fund. The measurement is usually reported for a 12-month time period.”
Blanchett frames the topic of portfolio turnover in the context of institutional investors such as mutual funds and/or pension funds.
According to Blanchett, the negative impact of turnover is most clearly demonstrated in four specific categories. First, through the spread between the bid and ask which was traditionally higher (more expensive) when stocks were quoted in fractions. Second, through the commissions paid for entering and exiting a transaction which is relatively low compared when using a discount brokerage. Third, through the higher cost of short-term tax rates for positions held for less than a year. Stocks held for less that a year are currently taxed as high as 35% whereas stocks held for a year or longer are currently taxed at rate of 15%. Finally, Blanchett considers the market impact of buying or selling a stock in relatively illiquid stocks which impacts the ability to enter or exist a stock on favorable terms. All of these factors negatively impact the return on a given stock as the level of turnover increases thereby reducing gains or increasing losses.
The article by Blanchett concludes that for every 100% of turnover in the portfolio there is a pre-tax loss from 19 basis points (-0.19%) to 98 basis points. Other studies mentioned in the article demonstrate that for every 100% of portfolio turnover there is a pre-tax loss of 225 bps (-2.25%).
Overall, the article by Blanchett is clear and succinct allowing for a justification as to why buy-and-hold investing is the preferred strategy for institutional fund managers. The New Low Observer portfolio is susceptible to high turnover due to the willingness to take large initial positions and sell when the stock attains a 10% gain. In addition, the size of our portfolio cannot be measured in the billions and therefore amplifies the effects of commissions and minimizes the effect of market impact. The topic of portfolio turnover is worth considering if you plan to buy and sell stocks with positions that comprise less that 5% of the portfolio.