Both value investing and focus investing aim to keep portfolio turnover very low. The turnover ratio describes the amount of activity in a portfolio. For example, if a portfolio manager sells and re-buys all the stocks in the portfolio once a year, or half the portfolio twice, the turnover ratio is 100 percent. Sell and re-buy everything twice a year, and you have 200 percent turnover.
My investment philosophy includes a simple principle: once a stock has been properly selected and has proven itself, it is only occasionally that there is any reason for selling it at all. Therefore, I prefer a low turnover approach to investing. This approach has two additional benefits:
1. It works to reduce transaction costs
2. It increases after-tax returns
On the average mutual funds generate between 100 percent and 200 percent turnover ratios per year. Studies have shown that funds with low turnover ratios outperform funds with high turnover ratios by as much as 14 percent over a 10 year period. The bottom line is every time you trade it costs money, i.e. add brokerage costs, which works to lower your net returns.
Another important economic advantage of low turnover funds is the postponing of capital gains tax. The more you turn the more you increase your tax liability. Every time a stock is sold, and a capital gain is realized, the capital gains tax is incurred. Therefore, not only does any new stock purchased have to outperform the stock it replaced, it has the anchor of outperforming the capital gains tax associated with the stock it replaced as well. Few investors realize this, but taxes are often the biggest expense that they face.
When a stock appreciates in price and is not sold the increase in value is unrealized gain. No capital gains tax is owed until the stock is sold. I prefer to leave the gain in place, allowing my investments to compound more forcefully. Warren Buffett calls this “an interest-free loan from the Treasury.” Interestingly, but counter intuitive, is that the greatest tax damage to a portfolio occurs at the outset of turnover and then diminishes as turnover increases. A study by Jeffrey-Arnott showed that, at a 25 percent turnover ratio, the portfolio incurs 80 percent of the taxes that would be generated by a portfolio turnover ratio of 100 percent. Therefore, I am mindful of my turnover ratio even though it’s in the low range. My target turnover ratio is somewhere between zero and 20 percent.
Be extraordinary!
Myles Rennie
My investment philosophy includes a simple principle: once a stock has been properly selected and has proven itself, it is only occasionally that there is any reason for selling it at all. Therefore, I prefer a low turnover approach to investing. This approach has two additional benefits:
1. It works to reduce transaction costs
2. It increases after-tax returns
On the average mutual funds generate between 100 percent and 200 percent turnover ratios per year. Studies have shown that funds with low turnover ratios outperform funds with high turnover ratios by as much as 14 percent over a 10 year period. The bottom line is every time you trade it costs money, i.e. add brokerage costs, which works to lower your net returns.
Another important economic advantage of low turnover funds is the postponing of capital gains tax. The more you turn the more you increase your tax liability. Every time a stock is sold, and a capital gain is realized, the capital gains tax is incurred. Therefore, not only does any new stock purchased have to outperform the stock it replaced, it has the anchor of outperforming the capital gains tax associated with the stock it replaced as well. Few investors realize this, but taxes are often the biggest expense that they face.
When a stock appreciates in price and is not sold the increase in value is unrealized gain. No capital gains tax is owed until the stock is sold. I prefer to leave the gain in place, allowing my investments to compound more forcefully. Warren Buffett calls this “an interest-free loan from the Treasury.” Interestingly, but counter intuitive, is that the greatest tax damage to a portfolio occurs at the outset of turnover and then diminishes as turnover increases. A study by Jeffrey-Arnott showed that, at a 25 percent turnover ratio, the portfolio incurs 80 percent of the taxes that would be generated by a portfolio turnover ratio of 100 percent. Therefore, I am mindful of my turnover ratio even though it’s in the low range. My target turnover ratio is somewhere between zero and 20 percent.
Be extraordinary!
Myles Rennie
RSS Feed