At Anchor we believe that in a taxable account, looking at only Anchor’s reported performance provides an incomplete picture. Why? The reported numbers are returns before taxes. What is left in your portfolio after taxes can be a different story. Determining the tax-efficiency of your portfolio is an important step in understanding your total long-term returns. A study conducted by Lipper [sup]i[/sup] shows that the average mutual fund generates a tax liability that can reduce a portfolio’s return by 1.4% to 2.4% annually.
How then should an investor compare the tax efficiency of different investment strategies? We believe one answer to this question is found by looking at the trading activity. Most mutual funds generate high tax liabilities because they actively trade stocks. The level of trading activity, measured as the percent of the total fund traded annually, is defined as “Portfolio Turnover”. High portfolio turnover, as the Lipper and other studies show, generates tax liabilities. Thus, the “Portfolio Turnover Ratio” is one good proxy for the tax efficiency of a portfolio.
On an asset-weighted basis, the universe of equity mutual funds available in the U.S. has an average portfolio turnover ratio of 61%[sup]iii[/sup]. In comparison, Anchor’s privately managed value strategies have significantly lower turnover ratios. We believe that comparing turnover ratios to reported returns provides the investor with a clearer picture of the potential tax efficiency of the strategy.
Turnover also affects the trading costs inflicted on a portfolio. High turnover leads to high trading costs. A 2013 study in the Financial Analysts Journal[sup]iv[/sup] concluded that “if a fund is able to recover these costs with superior returns, these expenditures might enhance overall (net) performance. This, however, does not appear to be the case”. This article found a strong negative correlation between aggregate trading costs and fund performance. In fact, the data show that trading costs, defined as “visible costs” such as commissions and “invisible costs” such as price impact, combined with turnover metrics, show a clear pattern of decreasing risk-adjusted performance as trading costs increase. Many managers seem to chase short-term price moves hoping to enhance short-term performance. In our opinion the reality is that this seldom works. Additionally, the tax liability on short-term capital gains (less than one-year holding period) can be as high as 40% vs. 20% for long-term capital gains.
Portfolio turnover is a two-edged sword. Not only can excessive turnover lead to tax liabilities, it also inflicts trading costs that reduce returns. Thus, high turnover, even in a non-taxable account, can contribute to lower returns. We believe that high turnover is a reflection of low conviction.
The low turnover in Anchor portfolios is a function of our disciplined value strategy, which aligns with the longterm prospects of our holdings. We conduct our own research, selecting securities on a bottom-up basis for inclusion in client portfolios. Over time, this has enabled our clients’ holdings to compound in a highly tax efficient manner.