Your advisor may recommend a long-term approach, but how many funds follow that advice?

One thing that I find intriguing about the mutual fund industry is how often it contravenes its own collective advice. Comparing word and deed can lead to some fascinating insights.

A practical example I would offer is in regard to portfolio turnover. It’s probably safe to say that a vast majority of advisors (and this is especially true for those who recommend primarily mutual funds) tell their clients to use a ‘long-term perspective’ when investing.

A single definition of what constitutes ‘long term’ does not exist. Rather, it is a subject where fair-minded people may differ. I’d suggest there’s a consensus that anything between 5 and 10 years would likely qualify as long-term to most advisors.

I’ll use a quick illustration of what a portfolio turnover rate is. If a fund manager trades 20% of the stocks in the fund in a given year, that fund would have a 20% annual turnover rate – making for an average holding period of five years. If a manager trades 14.2% annually, the turnover rate moves to seven years. If the manager trades 10% annually, the turnover rate moves to ten years. The math is quite simple. Turnover rate is the reciprocal of the holding period (in years). For instance, 1/5 = 20%, 1/7 = 14.2% and 1/10 = 10%.

The calculation considers both purchases (i.e. new money) and forced sales (i.e. to meet client redemption requests) in this calculation so that sometimes fund managers do more buying (if their fund is popular) or selling (if their fund is unpopular) than they would if managing a relatively static pool of capital. The question this begs is: How many fund companies assist their advisor ‘partners’ by manufacturing predominantly low turnover funds in order for advisors to remain intellectually honest in their recommendations? After all, advisors have to recommend funds from the universe of available products. While advisors have dozens of low turnover funds to suggest, they don’t necessarily have options in all fund families to make such recommendations.

In combining the use of mutual funds with a long-term philosophical approach, what might one expect the portfolio turnover of recommended funds to be? Can anyone who recommends (perhaps out of necessity) high turnover products genuinely be considered an advisor with a long-term perspective?

Whatever an acceptable “long-term” holding period is deemed to be, one would expect recommended mutual funds have a turnover rate that corresponds. Do they? Getting a clear answer requires a bit of spadework. First of all, there is no single place where these ratios can be aggregated and compared. If you want to know what a specific fund’s turnover rate is you’ll have to check the most recent prospectus as these ratios are not available in any newspapers or Internet site that I am aware of.

Regulators might say there is a ‘know your product’ imperative that advisors need to meet. But what if advisors do their due diligence and find that they are limited by equity funds with high turnover rates? This is an important consideration because it seems most commentators believe there are quantifiable benefits to low turnover funds.

Many studies have demonstrated this as well. Firstly, trading costs money. In a mutual fund environment, that leads to higher MERs, which are a drag on performance, other things being equal. Secondly, trading securities generally leads to higher tax liabilities when capital gains are triggered. The less you trade, the longer you can hold the tax man at bay. This is something people with non-registered mutual fund accounts are all too aware of when they receive their tax slips at the beginning of every year even if they themselves did not trade the funds themselves.

The current tendency toward high-turnover funds makes it awfully difficult for advisors to filter competing products that are consistent with their stated philosophical perspective. The absence of a readily accessible source to compare turnover rates makes it hard to quantify this problem.

At any rate, there’s likely a massive disconnect between word and deed. John Bogle, in his recent book ‘Enough’ defines turnover as the number of shares traded as a percentage of shares outstanding and says that in the U.S. market, turnover has risen from ‘about 25%’ in 1951 to above 100% in 1998.” He suggests the number has more than double since that time. What percentage of the long-term (equity) funds in the marketplace is taking a less than long-term perspective while being marketed almost exclusively as long-term investing vehicles? No one (that I know) knows for sure but no one doubts the number is very high, either.

Think of it this way. Let’s say a mutual fund has a turnover rate of 33%, leading to an average holding period of three years. If you were using stocks instead of mutual funds to build your portfolio and your advisor not only told you to take a ‘long-term view’, but also traded the entire portfolio every 36 months, how much credibility would he or she have? Where’s the accountability? Simply disclosing what the turnover rate is as opposed to disclosing the impact of a higher turnover rate (ceteris paribus) likely leaves consumers ill-equipped to make an informed decision.

One might argue the consideration is moot in non-registered accounts from a tax perspective. And from a cost perspective, the impact might be relatively modest, too. However, from an ethical and moral perspective, the difference can be substantial. I know of no one who seriously suggests 12 months is ‘long term’. I know of nobody who seriously suggests 36 months is ‘long term’. Nonetheless, that’s the kind of holding period we’re looking at for many mutual funds recommended by most advisors in Canada today. Many are shorter still.

Mutual fund companies manufacture products to meet the demands of a competitive marketplace. As such, it amazes me that advisors and consumers don’t put more pressure on fund companies to manufacture products that are both more consistent with company philosophies and more advantageous to end-user investors. As is the case with any product where the manufacturer doesn’t meet consumer needs, shifting your buying decisions to more suitable products should get serious consideration.

As a statement of fact, mutual fund manufacturers meet all the requisite tests regarding “full, true and plain disclosure” regarding their products when their prospectuses are cleared by various securities commissions and when they file with As such, while I do not dispute the technical requirements for the quantification of portfolio turnovers are being met, it’s just that I cannot help but wonder if more couldn’t be done to deal with what, to me at least, is industry-wide inconsistency.

Accordingly, here’s what I’d like to suggest to advisors reading this. First, ask your client what she or he considers to be ‘long term’. Next, ask yourself whether portfolio turnover is an appropriate proxy for time horizon. Following that, determine what the average portfolio turnover for the fund(s) being recommended (or held) is.

If the turnover number is in excess of the associated timeframe, you may need to explain your recommendations and think about things. Finally, if you agree with my premise that turnover is an appropriate proxy for time horizon, see if you can get your product manufacturer ‘partners’ to walk that talk. Press hard for something better by giving clear preference to products with turnover rates that are consistent with your (and your client’s) stated perspective regarding time horizon. Being consistent is just the decent thing to do and advisors need to clearly reconcile their product recommendations with their stated philosophies if they want to retain client trust and respect.

  • John J. De Goey, CFP, is a vice president with Burgeonvest Bick Securities Limited (BBSL). The views expressed are not necessarily shared by BBSL.