Q&A On Bond ETFs And Churn: Why Turnover Can Be Misleading

Includes: AGG, BND, SPAB
by: Matt Tucker, CFA

I’ve been getting a lot of questions lately about fund churn, or turnover, and its effect on a portfolio. In general, turnover is not considered a good thing because it can lead to higher capital gains, increased transaction costs and lower returns. That said there are good reasons why bond funds would naturally have more turnover than equity funds. Below, I answer a few of the most common questions about turnover, and I look forward to hearing back from you with additional questions on this topic or other fixed income subjects.

Q: How is turnover reported?

A: Studies have shown that stock portfolios that are churned tend to have lower long-term returns. In fact, the SEC requires that each 40 Act fund publish a portfolio turnover number in the fund’s annual shareholder report. Morningstar even gives guidance on how to interpret these turnover numbers, saying a low turnover ratio would be in the 20 to 30 percent range, while high turnover would be more than 100 percent. But this guidance is largely for equity funds, and is less meaningful for fixed income funds and fixed income ETFs, especially index funds.

Q: How does turnover differ between equity and fixed income funds?

A: A key difference is frequency: most equities indices are rebalanced annually, like the Russell Reconstitution each June. In contrast, most fixed income indices are rebalanced monthly. These take into consideration numerous market changes including cash flows from coupon payments, new bond issues, and bonds that have been called or paid down early. Fixed income index portfolios, therefore, are generally rebalanced monthly with their target indices in order to reflect these index changes.

Here is an example using the Barclays Capital US Aggregate Index:

Source: Barclays Capital as of 7/31/2011

As you can see, index additions over the past year total 19.8% of market value, while another 13.8% of market value was removed as bonds left the index. On top of that 4.2% of the index turned over as a result of paydowns on mortgage backed securities. Then there are coupon payments that must be reinvested — they contributed an additional 4.17%.

Add it all up and the total turnover in the index for the year was 42% of market value. So even a portfolio that is designed to track an index could incur turnover of around 42% just to keep up with index changes. An active portfolio seeking to outperform a benchmark would likely have even higher turnover as it would need to keep up with a shifting benchmark while also implementing its market views.

Q: What other factors impact turnover rates?

A: When looking at portfolio turnover, it is also important to consider cash flows into and out of the fund, and what instruments a fund invests in. A fund that uses derivatives such as futures contracts or mortgage TBA securities can exhibit higher turnover because these instruments need to be rolled forward on a regular basis. Each roll contributes to portfolio turnover. As a result, the turnover figure for a portfolio that uses futures or TBAs can appear high.

Q: Given the high turnover number for bond funds, how can an investor evaluate bond manager performance?

A: If the fund is an index fund, review the tracking error to the benchmark and any capital gains paid in the past. These will provide clues about the impact that fund turnover has had on investors. If the fund is active, conduct due diligence on how the portfolio is managed and what instruments are permissible. And in all cases understand the portfolio’s investment strategy and objectives.

At iShares all of our fixed income funds are managed to a total performance framework which explicitly considers tracking error, portfolio risk, and transaction costs when making portfolio decisions.

Disclaimer: Bonds and bond funds will decrease in value as interest rates rise. Past performance is not indicative of future results.

Mutual funds and ETFs are obliged to distribute portfolio gains to shareholders by year-end. These gains may be generated due to index rebalancing or to meet diversification requirements. Trading shares of ETFs will also generate tax consequences and transaction expenses.

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