How Active Fund Turnover Relates to Future Risk-Adjusted Returns

Summary

This research review presents a model in which active fund managers trade more when they see greater profit opportunities, then examines whether turnover predicts later benchmark-adjusted performance. Evidence from a historical sample of US active equity mutual funds shows a positive within-fund relationship between turnover and subsequent returns, stronger over time within a fund than across funds. The relationship is reported as stronger for smaller funds, funds trading less liquid stocks, and higher-fee funds. The review also describes a positive predictive association between peer-group average turnover and a fund’s later performance, even after accounting for its own turnover.

The authors connect elevated common turnover to conditions associated with mispricing, including investor sentiment, stock-level return dispersion, and lower market liquidity. These findings are consistent with managers reacting to changing opportunities, but do not prove that turnover causes better returns. The review notes that turnover measures imperfectly separate discretionary trades from flows, that prior cross-sectional findings have been mixed, and that the underlying evidence is historical and based on overseas data. It should therefore inform research hypotheses rather than be treated as investment advice.

Key ideas

• A model of changing profit opportunities predicts that active funds trade more when expected opportunities improve.
• Within a fund, higher turnover is associated with stronger subsequent benchmark-adjusted performance.
• The reported turnover-performance relationship is stronger within funds over time than across funds.
• Peer-group turnover may add predictive information beyond a fund’s own turnover.
• Turnover rises alongside several market conditions associated with greater potential mispricing.
• Historical associations do not establish causation, and turnover measures may retain flow-related noise.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.