Investment Turnover

Investment Turnover (or Average Holding Period) is an interesting topic for two reasons.

1. Allocators and IROs both rely upon it
2. Neither know how to define it

When I was running Clipper Capital Management, a long/short equity hedge fund, I must have met with 400 fund of funds analysts and portfolio managers. I also had the pleasure of meeting with dozens of very smart and wealthy individual investors.

The fund of funds employees would all ask me the exact same check-the-box questions, while individuals asked me all sorts of unique and intelligent questions. The individuals asked more insightful questions because it was their hard earned money on the line. The fund of funds were often more interested in populating a database in order to give their investors, the institutional allocators (pension funds and endowments) the impression that they were working hard.

The one question that I was consistently asked by fund of funds employees that I was never asked by individual investors was "what is your portfolio turnover?" The reason why individual investors never asked the question was because it wasn't important.

Ideally, investors would like to see lower turnover because it is commonly associated with lower taxes. However, more actively traded funds often sell losing positions for tax harvesting purposes in order to offset taxes associated with short term gains. Tax efficiency goes out the window if the portfolio manager is unable to generate sufficient returns. Is it better to invest with a manager that consistently produces above average returns but below average tax efficiency or a manager that buys and holds bad stocks?

I made it a practice to ask fund of funds employees to define portfolio turnover before I would answer the turnover question. The conversation often went like this...FOF: "what is your portfolio turnover?" Me: "That is an interesting question. Why don't you give me your definition of portfolio turnover and I will tell you what it is" FOF: (blinking with mouth agape) "Uh I don't know" Me: well it doesn't make much sense for me to give you a answer if neither you nor I really know what the question is". FOF: (blinking with mouth still agape) "Uh ok..."

I probably would have raised a lot more money from fund of funds investors had I not been such a smart ass, but I couldn't answer a question knowing that the person asking it failed to understand the implications of the answer.

As I was reading the Bank of New York 2009 Global Trends in Investor Relations Survey I came upon the following chart:



The second most important criteria that IROs use for investor targeting is average holding period. This made me smile. I immediately began to question where the data was coming from. Is it self reported by the portfolio managers? If so how can it be trusted?

I am sure that most portfolio managers actually provide a number when asked, but because that number is internally defined and calculated how can it be relied upon when comparing that manager to another? I could have randomly told every Fund of Funds employee that I met with that my portfolio turnover was .2 and they wold have written it down and put it in their database alongside many other investors who probably provided numbers much greater than .2. After all .2 is low....isn't it? This number sounds low but because nobody knows how to define it, how could anyone possibly verify it? The numbers do not compare investors on an apples to apples basis and are therefore meaningless.

Perhaps there are service providers who are selling this data to IROs. How are they calculating average holding period? If there is more than one vendor selling this data (which I imagine there is) are they calculating the numbers the same way? I imagine that they are not.

Regardless of how it is defined, average holding period can be manipulated in many ways:

1. Holding stock short against the box
   
2. Raising new capital
3. Meeting investor redemptions
4. Tax loss harvesting
5. Leverage
6. Long/short strategies
7. Measured time horizon
8. Age of fund
9. Personnel changes
10. Market volatility
11. Risk management policies

I understand the desire by IROs to focus on average holding period because investors who buy and hold are perceived to be more predictable, more reliable, more informed and lower maintenance. Be careful when making these assumptions. They might just be more lazy. Lazy investors tend to under perform their peers which over time can lead to investor redemptions and forced selling down the road.

The great investors who I have studied over the years have all been pretty good at cutting bad investments early and holding on to the stocks that outperform. I would argue that the average holding period for their winners is much longer than the average holding period of their losers. IROs and executive management must recognize that they play a very key role in determining the average holding period of their own stock. If you operate a solid business, execute against your plan and you keep your investors engaged, you can help reduce their desire to sell.

I would like to suggest an investor targeting technique that is not being widely used today. Adopt an "outperformer" targeting strategy. If you want to get your company noticed, target the institutional investors with the best 3, 5 and 10 year investment track records. I guarantee that most institutional investors are looking at the portfolios of these investors for ideas. I did it, and I personally know of hundreds of others who do the same thing. Work hard to get noticed by these consistent outperformers and other investors will quickly find you.

I would love to crowdsource a definition of average holding period from the IRO community and I would strongly urge IROs to question the service providers that are supplying this data and make them explain how it is calculated and verified.

Please share your thoughts with me about this topic.