High turnover managers must prove they are worth the transaction costs, according to industry commentators, who says this year has been particularly difficult to keep turnover low. 
While no fund manager actively goes out of their way to have excessive turnover in their portfolios, market conditions this year have meant there have been more funds chopping and changing their holdings to keep up.
The Share Centre head of investment research Andy Parsons says there are two scenarios where he would expect to see high turnover at different end of the spectrums.
“At the moment we are at exceptionally high levels so there is a potential opportunity that there may be managers holding companies that are reaching their price target,” he said.
“With all things being equal it could be that you suddenly find that the market is being particularly high and they may well sell.”
The FTSE 100 hit a new intra-day high of 7,129.83 last week and is still trading at near to record highs after slipping slightly since.
Performance of FTSE 100 over 10yrs
Source: FE Analytics
Parsons (pictured) adds that in this scenario, with prices at close-to record highs, many managers will look to sell some of their positions, with a diversified portfolio more likely to have companies reaching that point than concentrated, high-conviction portfolios.
The other time a fund may experience higher turnover is during times of market volatility, which has been the case on a number of occasions in 2016.
At the start of the year fear over the state of the Chinese economy had investors fleeing to safer havens such as gold, while the Brexit vote in June also caused much panic, with that market tanking only to rebound in the subsequent months.
“So we have times when the market is rising and we have things like June with Brexit when the market falls through the floor,” Parsons said, adding that this can “force or necessitate certain managers to have high turnover”.
Darius McDermott, managing director at Chelsea Financial Services, added: “Turnover is obviously a function of what managers need to do. If you think about pre- and post-Brexit environment, there will be some managers who have had higher turnover post-Brexit as they’ve wanted to readjust their portfolios to a new environment.”
However, while turnover does have a cost, it is not necessarily a bad thing for a fund.
“Turnover does have a cost – every time you trade there are costs associated, what we try to assess is whether the manager is any good, whether there is alpha generation coming not specifically from the turnover but from their style,” McDermott said.
He adds that the most likely funds are those that short, or have a ‘non-core’ element to their fund, aiming to beat the market and create alpha over a shorter time frame.
“If I think about something like Henderson UK Absolute Return, they have a core part of their book and a tactical part of their book and the tactical part of the book may well be that they get short-term pricing anomalies where they think that something is dramatically undersold and it may be that they’re proved right within half a day.”
Performance of fund vs index over 5yrs
Source: FE Analytics
The £1.7bn fund has outperformed the IA Targeted Absolute Return sector by almost double since its launch and has beaten the sector in every year apart from 2010.
The five FE Crown-rated fund, run by FE Alpha Managers Ben Wallace and Luke Newman, aims to achieve a positive return each year.
While some managers use their short book as a hedge, this fund uses it strategically as a profit making enterprise, meaning trades can be over a matter of days, or sometimes shorter, if an asset rebounds quickly enough.
McDermott said: “If something is off 5 per cent and it bounces back and is off 3 per cent they’ve made 2 per cent so then the cost of trading is clearly much less that the gain that they’ve made from it.”
However, both McDermott and Parsons generally prefer low turnover funds due to the lower fees incurred by this strategy.
Both point to industry veterans Neil Woodford and Terry Smith as examples of low turnover, high conviction managers that they would own.
Parsons said: “People say what is low and it’s very hard to gauge, you have to look at the portfolio as a whole first and you have to appreciate and appraise a whole raft of other criteria as well. There’s no black and white answer.
“The two that stick out to me as low turnover are Neil Woodford and Terry Smith and you may as well throw Lindsell Train in there as well,” he added.
Performance of funds since the CF Woodford Equity Income launched
Source: FE Analytics
As the above graph shows, since the launch of the CF Woodford Equity Income fund in 2014, all three funds (CF Lindsell Train UK Equity and Fundsmith Equity included) have performed strongly, despite remaining low turnover in a volatile period for markets.
McDermott said: “Terry turns over about 10 per cent per year, i.e. not a lot and Woodford is typically around the 25 per cent per year. Those are two managers with low turnover.”
He adds that while no fund managers go out of their way to have high turnover in their portfolios, he fears some are focusing on lower turnover to keep fees down.
“I think what we’ve seen is more and more people focusing on keeping turnover low. We don’t particularly want low turnover or not low turnover, we want managers to do what they’re good at and what their process leads them to. If turnover is a result of that then so be it.”
Colin McQueen, co-manager of the Sanlam FOUR Global Equity and Stable Global Equity funds, agrees that portfolio decisions should be made for investment reasons, not explicitly to keep costs lower.
“Our turnover is pretty low its averaged around 20 per cent per annum (or actually a bit lower) so we tend to hold stocks for four or five years once we’ve bought them,” he said.
“Whilst I think we’re all aware that there is a transaction cost from moving from one to another, for us that is not the primary drive. It’s a nice benefit, but it really falls out of how we think about investing and what we’re trying to achieve.
“For us our focus is more on trying to spot long-term advantaged companies at a point when they’re out of favour and we can pick them up at a good price.”