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One Important Thing to Look Out for in Funds

At Motley Fool Singapore, we are pretty much advocates for investing in the stock market through individual companies, and believe that the best person to do so would be you. But, there is a pretty good case to be made for investors who prefer to invest in the stock market through other means.

Investors can choose passively managed index trackers like the SPDR Straits Times Index ETF (SGX: ES3) or Nikko AM Singapore STI ETF (SGX: G3B), which aims to mimic the movements of the Straits Times Index (SGX: ^STI). Or, they can place their money with actively managed mutual funds and unit trusts.

These investment instruments give investors the ability to diversify their holdings at low cost. For example, one lot of Jardine Matheson Holding’s (SGX: J36) shares at US$67 per share requires an investment of at least US$67,000, but a fund or ETF can allow an investor to own Jardine Matheson and a host of other shares without investing such a large sum. And in the case of actively managed mutual funds and unit trusts, professionals are also there to provide additional returns for their shareholders through superior stock picking.

But, not every actively managed fund is created equal and there’s a very important piece of information about them that often goes unnoticed by investors – the Portfolio Turnover Ratio (PTR). In simple terms, the PTR can be taken as a proxy for the average holding period of a stock in any particular fund. For example, if fund XYZ has a PTR of 20%, it would mean that XYZ holds each stock in its portfolio for an average of five years (100% divided by 20% equals to five). Fund ABC would have an average holding period of six months if its PTR was 200% (100% divided by 200% equals to 0.5 years).

Activity Kills

In a Jan 2006 essay titled Journey Into the Whirlwind: Graham-and-Doddsville Revisited, Columbia Business School professor and attorney, Louis Lowenstein discussed the returns of two groups of funds in the USA.

One group consisted of growth funds which returned 8.1% per year over 10 years, ending on 31 August 2005. The other group consisted of funds with a value investing philosophy and had annual returns that averaged more than 13.1%. As a comparison, the US stock market grew by about 10% per year.

What were remarkable about these results were the portfolio turnovers for the funds in the two camps. The growth camp had an average turnover of 250% for the five years ended in 2003 – equating to an average holding period of five months for their stocks! The value camp, however, had a PTR that was a quarter of the growth camp’s.

A low PTR would correspond to a patient, buy-and-hold investing strategy that is favoured by some of the best investors around. Shelby Davis had thrashed the stock market with inactivity, while Bill Ruane was cited by Lowenstein that ‘low turnovers’ constitutes thoughtful investing.

Mutual fund legend Peter Lynch has been quoted as saying, “In my investing career, the best gains usually have come in the third or fourth year, not in the third or fourth week or the third or fourth month”. What all these means is that good investing results from buying shares in individual companies takes time to achieve, and patience (characterised by a low PTR) is a prerequisite. Nobody should expect great returns from investing in individual shares with a time frame expressed in months or weeks.

To provide some local context, I ran a basic screen from FundSingapore.com and found a list of funds and unit trusts with the worst performance records over the past 10 years based on Lipper’s ranking system. 10 years is an adequate timeframe to gauge the quality of a fund’s return. The three funds with the highest asset values – HSBC GIF Indian Equity, HSBC GIF Chinese Equity and Alliance Bernstein-Global Growth Trends – had PTRs for their last financial years of 48%, 248% and 56% respectively.

In contrast, three of Aberdeen Asset Management’s funds that had the best Lipper-ranked performance in the past 10 years had much lower portfolio turnovers. Aberdeen’s Global Opportunities, Pacific Equity and Thailand Equity funds had portfolio turnovers of 13%, 2% and 7% respectively.

An average holding period of 50 years seems ridiculous for Aberdeen’s Pacific Equity fund, which was only launched in 1997. But, what it really means is that the Pacific Equity fund places a real emphasis on patient investing, holding shares of companies for years.

Is the link between a fund’s PTR and the Lipper rankings a mere coincidence? I would think most probably not.

Foolish Bottom Line

Actively managed unit trusts and mutual funds can help provide additional returns if their managers were truly superior at stock picking. But, investors choosing such funds should have the right focus on the figures that matter and the PTR should not be ignored anymore.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.