There are many things to admire about the new KIID document. It surely doesn’t get everything right—the assignment of fixed bands for volatility, for example, seems somewhat odd as my colleague, Paul Kaplan, has pointed out. However, the KIID is at least a step in the right direction to providing investors with a clear and simple presentation of information that is pertinent to the investment decision.
That said, a fact that may have gone unnoticed as a consequence of the KIID is the disappearance of the requirement of fund groups to provide a portfolio turnover rate (PTR). Indeed, the IMA has removed the PTR requirement from its Statement of Recommended Practice, issued in October 2010, in light of this change.
The loss of the PTR in its present guise is not entirely bad. Whilst the PTR is meant to give investors a rough guide to trading activity within the portfolio, the PTR measure specified in the UCITS III directive and adopted in the UK was poorly designed to achieve this. The calculation ran as follows: Take the gross value of all buys and sells of portfolio securities in the period, net out the gross value of all inflows and outflows experienced by the fund in the period, then divide all of this by average net assets.
The calculation is non-intuitive and fails as a useful measure. Let’s simplify things a bit and imagine a fund where there are no outflows or inflows and where the portfolio manager sells all the securities in the fund and replaces them with different securities. To most reasonable people, this would be 100% turnover. The manager has changed out the entire portfolio. In the world of UCITS turnover, however, it’s 200%. Worse, the logic implicit in the measure is flawed and produces commensurately flawed results.
The UCITS calculation would only make sense if one assumes (questionably) that: (1) trading caused by inflows or outflows is deemed not relevant to judging portfolio activity, and (2) all flows cause trading activity (recall that the calculation subtracts the entire value of all gross flows from the value of trades made in the fund).
The first premise strikes me as false. While it might be useful to know which turnover resulted from the manager’s strategy versus that resulting from flows, all trading has a cost and investors in the fund are impacted accordingly. As inflows and outflows are a necessary part of open-end vehicles, dismissing trading activity and costs that owe to flows is misguided. The idea that all flows trigger trading activity is incorrect. Managers net flows against each other and may also be able to fund redemptions from cash on hand or trades that had already been planned or were in progress. Similarly they may choose to hold new inflows in cash.
The result of this is that when using the UCITS calculation, turnover can be negative. Take, for example, a £100 million fund that experiences inflows of £10 million each month and outflows of £10 million each month. If the manager nets the flows perfectly in our simplified example, he will not have to execute any trades. However the UCITS calculation in this case gives us turnover of (0 – (£20mil x 12 months))/£100mil, or -120%, without the manager having executed a single trade.
So, whilst we can see why the PTR using the existing measure might be unhelpful, turnover using a better measure would serve as a useful rough guide for investors as to the potential trading costs incurred by their fund and an indicator of the capacity of a given strategy. Doing away with the PTR requirement in its entirety therefore marks a step backwards in transparency.
Jurisdictions including Australia and the U.S. seem to have got their heads around it better through the use of a simple calculation that takes the lesser of the value of securities purchased or sold, and divides this value by average net assets. To adopt something similar here would do away with the complexity and accompanying flaws referenced above and give investors a reasonable guide to the level of trading activity in their portfolios.
Whilst, ultimately, we’d like to see funds report their trading costs as a percentage of assets, a PTR using a simpler calculation would be a step in the right direction.
This article was first published in Investment Adviser.
