Have you ever wondered how a “low-cost” fund really makes its money? The dirty little secret: turnover. Even when expense ratios look cheap on paper, many funds make up the difference by churning their portfolios, buying and selling stocks at a pace that quietly eats into your returns.
Example
I once had a prospect who came in with a portfolio of “low-cost” Exchange Traded Funds (ETFs). He felt good the expense ratios were under 0.8%, but when we ran the numbers, some of his funds had thousands of positions and his total portfolio had over 40,000 positions. That means they were trading 3,200 times a year.
He shook his head and said, “So my ‘cheap’ funds are just trading machines? That’s not what I thought I signed up for.”
The Problem: Turnover = Hidden Costs
- Trading drag: Every trade has costs: bid/ask spreads, commissions, and market impact. These don’t show up in the fund’s expense ratio.
- Taxes: Turnover creates short-term capital gains, which are taxed at higher rates than long-term gains.
- Underperformance: Morningstar research shows funds with extreme turnover often lag their benchmarks after costs.
Brendan McCann of Morningstar highlighted an ETF with turnover ratio as high as 4712%, meaning the entire portfolio flipped dozens of times in one year. Imagine the hidden costs buried in that.
Why This Happens
Brokerages like Schwab and Robinhood can offer “free” trades because trading itself is profitable. Fund managers aren’t paying commissions the same way individuals do, but they still generate spreads, slippage, and realized gains. You just don’t see the bill directly.
The Smarter Alternative: Long-Term, Research-Driven Portfolios
Turnover isn’t the same as being active.
- High Active Share ≠ high turnover. You can have a portfolio that looks very different from the index but still holds companies for years.
- Institutional managers with SMAs often build concentrated portfolios they hold long-term, reducing turnover while still providing active, research-driven conviction.
- Compare:
- Fund with 1,000 stocks and 15% turnover = 150 trades.
- Fund with 50 stocks and 20% turnover = just 10 trades.
Focus reduces noise and reduces unnecessary trading.
The SMA Advantage
With an SMA, you:
- Own stocks directly, not pooled in a trading machine.
- Have transparency into trading activity.
- Work with your advisor to manage turnover and harvest taxes intentionally.
- Keep costs low while still benefiting from institutional research.
In Summary
“Low-cost” doesn’t always mean low-cost. Turnover is the hidden leak that drains performance and inflates your tax bill.
With SMAs, you get research-driven portfolios that hold companies long-term, keeping turnover low and intention high.
Ready for research-driven portfolios that keep trading costs low? Let’s talk about SMAs.
References
- Barber, B. M., & Odean, T. (2000). Trading Is Hazardous to Your Wealth. Journal of Finance.
- Morningstar Research (Brendan McCann, 2020): ETF turnover statistics.
- Cremers, M., & Petajisto, A. (2009). Active Share and Fund Performance.
- Barber & Odean (“Trading Is Hazardous to Your Wealth”) show that individual investors with high turnover significantly underperform after costs.
- Notre Dame & Active Share studies show many funds behave almost like index funds partly because high diversification & high turnover dilute active bets.