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Can High Turnover Improve Returns?

By Louis Llanes | October 5, 2018

When a portfolio manager is trading often and turning over the portfolio many times in a year, investment returns are reduced due to costs of trading.

By Louis B Llanes, CFA CMT
Founder, Wealthnet Investments, LLC

When a portfolio manager is trading often and turning over the portfolio many times in a year, investment returns are reduced due to costs of trading.  Essentially, the common belief is that high turnover is always bad.

As with any generalization, there could be exceptions to the rule.

In this article I’ll present a study my firm did on a momentum strategy combined with a simple market timing model.  I will show a test of trading more frequently in companies with strong trend and overlaying a market trend indicator to isolate trading when the trend in the overall stock market is higher.  This will then be compared to the buy-and-hold index after commission costs.

Academic studies[i] have discussed the “momentum” anomaly for years and how trading companies with strong momentum has historically outperformed passive indexes such as the S&P 500.   The question becomes, is high turnover necessarily bad for a momentum strategy?

Filtering for Uptrends

We’re going to look at a study we did of the stocks in the S&P 500 from 1/1/1990 to 10/1/2018.   We tested a trading a strategy of buying the strongest momentum stocks only when the S&P 500 was in a quantifiable uptrend.   We are including historical constituents that could have been traded to remove survivorship bias.   We want to include all the companies that have gone out of business to ensure our results aren’t biased.
Out of these stocks, our test only buys those with the highest 12/1 momentum.   We only want to buy these stocks when the market is in an uptrend and rotate and rebalance these monthly.

How do we measure the market uptrend? It’s really simple – We have two filters that we look at. The first filter is on the S&P 500 index.  If the S&P 500 this month is greater than the average close over the last 12 months, we’ll consider that an uptrend.   The second filter is tested on each individual stock.  Each stock can only be purchased if the close is above the 12-month moving average as well.  If these filters are not true, the no more purchases are considered, and stocks are removed at the next rebalance date if they don’t qualify.

S&P 500 Moving Average

The chart below illustrates the S&P 500 index with red arrows indicating when the market is no longer in bullish mode because the close is less than the 12-month moving average.  It's not a perfect indicator, but it provides a reasonable indication of the general direction in the market.   If the market starts heading lower, this indicator will discontinue new buying of stock. Only exits from trend conditions in the stocks will keep you long the stocks. After looking at those initial filters, we move onto the relative strength or momentum part of the back-test.

[i] Returns to Buying Winners and Selling Losers:  Implications for Stock Market Efficiency, Journal of Finance, Volume 48, Issue 1 (Mar., 1993) 65-91, Narasimhan Jegadeesh, Sheridan Titman

Two Centuries of Price Return Momentum, Financial Analyst Journal, Vol 72, NO. 5 (September/October 2016), Christopher Geczy, Mikhail Samonov

Dissecting Anomalies, The Journal of Finance, Vol LXIII, NO. 4 August 2008, Eugene F. Fama and Kenneth R. French

 

12-1 Momentum

12-1 momentum is defined as the 12-month rate of change in price minus the one-month rate of change in price.  It is a monthly measure, so it tends to limit frequent whipsaws that can be associated with daily or weekly measurement.   In this test, we ranked the S&P 500 stocks each month by 12-1 momentum and bought the 30 highest ranked stocks and rebalanced every month.   The chart below shows an example of 12-1 momentum on Apple Inc. (AAPL).  The green histogram on the bottom of the chart plots the 12-1 momentum over time.

Results of the Test Period

Let’s look at the back testing illustrated on the chart below.  The blue shaded graph is the value of $100,000 invested in the strategy and the red line is the value of the S&P 500 buy and hold index.  The strategy displayed significant alpha over the index.  The annualized returns of the system were 16.1% with an annualized volatility of 17%.  This compares to an index annualized return of 8.6% with volatility of 14%.

Another important statistic to note is that there were times when cash was held.  The yellow graph plots the cash balances over the test period.  Higher cash balances were involved when the market trend indicator would not allow more stock purchases and stocks were exited when they no longer met the trend and relative strength criteria.

The test results considered a $5 per trade commission which represents the commission rates paid by many retail investors at large discount brokerage firms.

The red histogram chart below the simulated portfolios shows the drawdowns. This measures the percentage decline from peak equity values.   The maximum drawdown over the test period was 32 percent.  Although this is a rather high drawdown it is lower than the drawdown of buy-and-hold S&P 500 index.

Alpha Architect on Momentum

Another example of how higher turnover can improve a momentum strategy comes from Wes Gray, PhD.  Mr. Gray is an accomplished quantitative portfolio manager and the CEO of Alpha Architect.  His firm managed exchange traded funds and separate accounts.  In this chart, courtesy of Wes, it compares the returns of a momentum strategy with various concentration and turnover.

The table indicates that higher returns are generated with less stocks and higher turnover.  The point of this chart is that if you hold too many stocks and do not turnover the portfolio enough, you will perform closer to the passive index.

What about Commissions, Impact Costs and Taxes?

How much does turnover matter for a trader who is focused on relative strength?   Some of the concerns such as excess trading costs and taxes can be mitigated.  First, investors can trade liquid stocks like the S&P 500 or the Russell 1000 to reduce impact costs.  Second, commission rates have fallen dramatically over the years.  Some brokerage firms charge fractions of a penny per share and others charge flat fees that can reduce overall commissions.  Lastly, taxes can be mitigated in a couple of ways, first, an individual investor could trade this in tax deferred accounts or tax free accounts.  Another way could be to invest in an ETF like Alpha Architect products.  Because of the ETF structure, most of the tax problem is reduced or even potentially eliminated long run.

Summary

Higher turnover is not always bad – and in fact can be good with a relative strength / momentum approach especially if traded in a tax deferred account or ETF.  If you can deal with taxation and impact costs, this data suggests investors could benefit from a little more turnover in their portfolio.

 

 

[1] Returns to Buying Winners and Selling Losers:  Implications for Stock Market Efficiency, Journal of Finance, Volume 48, Issue 1 (Mar., 1993) 65-91, Narasimhan Jegadeesh, Sheridan Titman
Two Centuries of Price Return Momentum, Financial Analyst Journal, Vol 72, NO. 5 (September/October 2016), Christopher Geczy, Mikhail Samonov
Dissecting Anomalies, The Journal of Finance, Vol LXIII, NO. 4 August 2008, Eugene F. Fama and Kenneth R. French

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