Readers of our monthly articles will have figured out that the review of factors, qualitative and quantitative, are core to the due diligence process of investments. Our clients who have read our proprietary due diligence reports will know that we include both types of factors in our analysis. Our due diligence reports are about 4 pages long on average, and certainly they could be longer or shorter. We know, however, the rule of diminishing marginal returns is as true for due diligence as anything else. In other words, each additional piece of information (e.g. a financial ratio, a metric of risk, information about an investment manager’s parent company) will provide less and less use to the reader as reports get bloated. We’ve tried to create a balance of providing sufficient information to understand an investment’s profile relative to peers without overloading the reader with only semi-relevant data.
Everyone can agree on including the bid ideas: risk, returns, and the basic philosophy of the product. Still, given we try to keep the reports short, we are called upon to defend the existence of certain metrics. Let’s look at one lesser used metric: the turnover ratio, or just “turnover”.
Turnover, simply, is how fast an investment manager rotates through the portfolio with new purchases and sales. Think a retail store’s warehouse. If the warehouse manager fills up the warehouse with goods and empties it completely within a year, that’s a turnover of 1, or 100%. If the warehouse manages to sell out of the inventory two full times during the year, that’s a turnover of 2, or 200%. An investment’s portfolio is measured in the same way. A higher-frequency trader may rotate through their portfolio of stocks and bonds 10 full times during the year, and may have a turnover of 10, or 1000%. Conversely, a buy-and-hold investment manager hangs onto their stock picks for an average of 10 years, only making small adjustments along the way; that investment manager would have a turnover of 0.10, or 10%.
Ok, that’s turnover. Why is it included in our due diligence reports?
First, it tells you something about the style of the manager – how active they are in buying and selling positions. Also, turnover may change over time and give you clues about what the investment manager is betting on. For instance, what if the ABC stock portfolio has a bad year and the fund’s turnover ratio falls. It may be a sign the portfolio manager is hanging onto some positions which have suffered in the marketplace, believing that the stocks are simply underappreciated and due for a price recovery. Or worse, what if ABC’s stock portfolio takes an extreme dip, but the fund’s representatives tell you that the managers are hanging onto those supposedly undervalued positions. Watching for dissonance or changes in the turnover ratio can provide corroborating (or contracting) evidence of an investment manager representative’s narrative during times of stress.