Sponsors of 401(k)-type defined contribution plans and of defined benefit pensions are tasked with ensuring that fees charged by mutual funds within their plans are reasonable. Typically, this means paying attention to a fund's stated “expense ratio”—the administrative fee charged by fund managers, which typically falls between 0.1 percent to slightly above 1 percent annually.
Plan sponsor fiduciaries, however, have paid less attention to "turnover" rates within mutual funds—the percentage of fund assets that fund managers buy and sell within a given year. Each transaction conducted by fund managers results in a trading/brokerage cost that is not included in the fund's expense ratio but that is deducted silently from a fund's assets.
Portfolio turnover rates, while less prominent than expense ratios, can be found in mutual fund fact sheets and on fund web sites. However, new research reveals that some fund managers underestimate turnover and often do not live up to their stated claims when it comes to the holding periods for the stocks in their fund portfolios.
The study of more than 800 institutional funds and how they are traded was conducted by HR consultancy Mercer and the not-for-profit Investor Responsibility Research Center Institute (IRRC Institute). According to the study report, Investment Horizons – Do Managers Do What They Say?, nearly two-thirds of institutional fund managers exceeded their expected turnover from June 2006 through June 2009. The turnover was on average 26 percent higher than expected, with some funds reporting turnover between 150 and 200 percent more than expected.
“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,” comments Jon Lukomnik, program director for the IRRC Institute. “The findings should raise serious questions.”
“A deviation in actual vs. expected turnover can be a possible indicator of deeper problems with investment processes,” adds Danyelle Guyatt, the head of research for Mercer’s responsible investment team and the report 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,” she notes.
Fund 'Style' Matters
Among other key study findings:
• "Value" fund managers tend to have a lower annual turnover figure than "growth" and "blend" style types. Large-capitalization funds have lower turnover rates than small-cap funds, and socially responsible investing (SRI) funds have lower turnover than non-SRI funds.
• Fund managers recognize the potentially destructive nature of "short-termism" (defined as an average holding period of 12 months or less) even while claiming it is unavoidable. Managers agree that excessive trading demonstrates a lack of discipline in fund managers’ investment processes and creates a misalignment of interests between fund managers and their clients.
Fund Asset 'Overlap': Another Metric to Heed
The level of diversification across retirement plan investment options is being given increased importance by plan sponsors in light of the high level of volatility in the financial markets. But "in the setting of a self-directed plan, the level of diversification achieved by investing in multiple funds may be significantly less than implied, because standard reporting does not show the level of identical assets within funds," notes investment adviser Stan Lochrie, co-author of a new white paper recommending that plan fiduciaries measure plan-level diversification, including the overlap in holdings among various funds.
"Analysis based on underlying holdings of mutual fund plan offerings has not been established as common practice, because it has historically been time- and cost-prohibitive and yielded out-of-date information," says Lochrie. The good news: Because of "a number of factors such as accelerated filing deadlines and improved technologies, there are now several providers of this information."
Stephen Miller is an online editor/manager for SHRM.
The Hidden Costs of Mutual Funds, Wall Street Journal, March 2010
High Trading Is Bad News for Investors, Wall Street Journal, February 2010
Most Companies to Restore 401(k) Match in 2010; Other Steps, SHRM Online Benefits Discipline, February 2010
401(k) Fees Matter: Tips for Reining Them In, SHRM Online Benefits Discipline, August 2007
Hide in Plain Sight: Finding Hidden Fees in 401(k) Plans, SHRM Online Benefits Discipline, February 2006
On the 401(k) Menu—Do More Funds Help Participants Diversify?, SHRM Online Benefits Discipline, August 2005
SHRM Online Benefits Discipline