Are Fund Managers Churning Portfolios More Than They Say?

Some equity fund managers are talking the talk, but not walking the walk -- by churning their portfolios and taking too short-term a view. A new study, Investment Horizons -- Do Managers Do What They Say? finds that some active equity fund managers have higher portfolio turnover rates than they themselves claim.The study, conducted by Mercer, a consulting firm, and funded by the not-for-profit Investors Responsibility Research Center Institute, demonstrates that investment managers themselves underestimate turnover. What's more, it shows that they often do not live up to their stated claims when it comes to the holding periods for the stocks in their portfolio.

Indeed, nearly two-thirds of institutional investor-focused investment strategies exceeded their expected turnover from June 2006 to June 2009. Of these strategies, the turnover was on average 26% higher than anticipated, with some strategies reporting turnover between 150% and 200% more than expected.

"Short-term investing is often cited as an issue by the press, policymakers, academics and many in the business and investing community," Jon Lukomnik, program director for the IRRC Instituted, said in a statement. "What has not been recognized until now is that this is not only particular to day traders or arbitrage funds or others who may have short time horizons by design. When two-thirds of long only equity institutional investment products have turnover that exceeds what they themselves expect, there is a systemic issue."

Cost, Performance And Risk At Issue

The findings should raise serious questions for investors. "When managers greatly exceed their expected turnover level, the impact can be significant, in terms of cost, performance, and risk that the strategy is not being managed in line with its stated investment approach," said Lukomnik.

There are other worries, as well, experts say. "A deviation in actual versus expected turnover can be a possible indicator of deeper problems with investment processes," said Danyelle Guyatt, the head of research for Mercer's responsible investment team and the report's co-author. "Clients interested in a strategy that seeks to capitalize on longer-term trends and hold stock in corporations for longer periods need to be aware if that situation is changing and why."

What's causing short-termitis? Mercer's follow-up with fund managers found the culprits to be market volatility and changing macroeconomic conditions; the emergence of short-term traders, such as hedge funds; mixed signals from clients; and short-term incentive systems. Furthermore, part of what is going on is behavioral, explained Lukomnik.The fact that everything is measured quarterly, sometimes even monthly, ups the pressure.

Be Aware Of What You're Buying

"There is research that shows that some CFOs and CEOs will not make positive long-term investments if doing so will affect the next quarter's numbers," Lukomnik said. "They are afraid of missing their numbers." From the fund manager's perspective, they may feel compelled to take action. "It's hard to justify your existence if you're doing nothing, even if doing nothing is the right thing to do. If somebody asks you how you earned your pay today, nothing might be viewed as a wrong answer," he said.

Though fund managers said they recognized the potential negative consequences of short-termism, they claimed it was unavoidable. So what's the takeaway for individual investors? Parallel studies show similar results for individual investors. "People tend to look at expense ratios and managerial fees, but they don't look at turnover, which is a data point to consider too. Turnover in a mutual fund increases costs and also makes it less tax efficient," said Lukomnik.

The advice for both institutional and individual investors: "Be aware of what you're buying. If you're told that it's a long-term value investment and there's turnover of 150 percent," Lukomnik said. "You should be asking a bunch of questions."
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