I kept thinking why was excess volatility so low for Quant MFs and I reached out to a client who runs a large advisory set up and asked him. "Do you know their turnover? I have an intuition it's very high". The client said, "It's acknowledged that their turnover is very high". I had my answer for how despite more than half of the segment data showcasing negative excess volatility, the fund was actually taking excessive risk to generate its incremental alpha. Let me introduce you to the magic of turnover and why you should not touch funds with turnover higher than annually 50%.

What is Turnover?

Turnover in a mutual fund context refers to the percentage of a fund's holdings that are replaced over a specific period, typically a year. It is a measure of how frequently the assets within a fund are bought and sold by the managers.

What is Good and Bad Turnover?

A lower turnover rate indicates a buy-and-hold strategy, which is generally associated with lower costs and greater tax efficiency. Conversely, a high turnover rate suggests frequent trading, leading to higher transaction costs and potentially significant tax liabilities. While a moderate turnover can be beneficial in adjusting the portfolio to market conditions, excessively high turnover can erode the fund's returns.

How High is Quant MF's Turnover?

Quant Small Cap Fund has an exceptionally high turnover rate. Here is a comparison table with the turnover rates for Quant mutual funds with inception before 2020.


Source: Monthly Portfolio May 2024 Quant MF

Why is Turnover Bad?

High turnover is detrimental because it is associated with lower gross alphas, and there is no evidence of year-over-year persistence of outperformance among fund managers [1]. High turnover leads to higher costs, which reduce the overall profitability of the fund. Additionally, it introduces greater volatility and risk, making the investment less stable and predictable.

What’s Turnover Hiding?

High turnover can mask underlying issues within the fund. It can be used to disguise poor performance by frequently changing the portfolio in hopes of capturing short-term gains. This strategy often leads to inconsistent returns and higher risk, as the fund is constantly exposed to the volatility of new positions.

Is it Normal for High Turnover to Produce High Returns?

No, it is not typical for high turnover to consistently produce high returns. While there may be short-term spikes in performance, these are often unsustainable. Frequent trading increases costs and taxes, which can erode any potential gains. The Quant Small Cap Fund, for example, has shown significant periods of underperformance despite its high turnover. The average alpha for funds before 2020 was 4.57% assuming no benchmark heist [2]. This does not adjust for the top 10 concentration risk, which was higher than the average benchmark. This was owing to the basket size. The average basket size, i.e., the number of components, was 22.73. Simply speaking, you are buying into a super-concentrated fund, which turns over an average of 377% every year. You don’t need a CFA Advisor to tell you that you are buying an extremely risky portfolio.

Why Does Quant Factsheet Not List Standard Deviation But Only Talks About Derived Risk Measures Like Sortino, Sharpe, etc.?

Quant MF’s factsheet emphasizes derived risk measures such as Sortino and Sharpe ratios, potentially because these metrics can present a more favorable view of the fund’s performance by focusing on risk-adjusted returns rather than raw volatility. Standard deviation, a direct measure of volatility, might reveal the higher risk inherent in the fund’s strategy, which is not as flattering and not listed in the factsheets.

What Does Quant MF Think About Turnover?

Quant MF posits that the portfolio turnover ratio is irrelevant. They argue that whether turnover is high or low does not inherently provide meaningful information about the portfolio's ability to generate returns or manage risk. They claim that, globally, active money managers naturally have high turnover as they dynamically rebalance their portfolios based on market conditions. [3]

Why Should You as an Investor Care?

Investors should care about high turnover because it directly impacts their net returns. High turnover leads to higher costs, which reduce the overall profitability of the fund. Additionally, it introduces greater volatility and risk, making the investment less stable and predictable.

How is it Connected to Excess Negative Volatility?

High turnover can lead to two tailed excess volatility (negative and positive) [4], as frequent trading often results in inconsistent returns (negative and positive). For Quant Small Cap Fund, 56.41% of its performance segments exhibited annualized excess negative volatility, meaning that in many periods, the fund’s returns were lower than expected and were accompanied by lower level of risk.

How Can High Turnover Be Connected to Front-Running?

Excessive liquidity and frequent trading in a high-turnover fund can benefit market makers and frontrunners rather than investors. Front-running involves trading ahead of large orders to profit from the subsequent price movements, which is more feasible in a high-turnover environment where large volumes are traded frequently.

High Turnover, High Concentration Brings Back Memories of Nick's Derailed Train

I wrote back on April 27, 2021 [5]. The portfolio advisor carried the article, “James Anderson and Nick Train leave Warren Buffett in the dust over the last 20 years.” James Anderson has retired, and Nick is still at the top of the table with 1600% returns over the last 20 years. The article focused on top performers and showed Warren Buffet at the bottom of the table with a 500% return for the period, compared to 300% returns of the S&P 500 for the respective period.

Last month he apologized for underperformance. The FGT [Train's Fund] turnover is a lot lower than Quant MF. A MF is not designed to be fool proof and deliver perpetual alpha. Active Investing is an impossibly difficult task. But when you churn your portfolio as much as 600% a year, you are taking excessive risk with investors money. And the risk is more likely to take you high before it destroys the party. How long this party lasts is hard to say, but being in the fund management business, I believe it's my job to highlight the risks and nudge the industry to better practices, where real asset managers and real skill is identified and does not stay buried in the noise of returns derived from excessive turnover.

Bibliography

[1] In pursuit of alpha: Evaluating active and passive strategies. James J. Rowley, Matthew C. Tufano. Published 2017. Business, Economics.

[2] Benchmark Heist

[3] Quant Mutual Funds Factsheet

[3] Warren, SPY, Machines, and the Concentration Risk!

[4] Is India’s Quant MF Really Frontrunning?

[5] Nick Train apologizes for poor performance, Financial Times