Portfolio churn is a slightly naughty word in the financial adviser / investment manager profession.
So why is churn a slightly dark concept, and why is avoiding portfolio churn an excellent thing for financial advisers to aim for?
What is portfolio churn
Churn refers to the amount of transactions in an investment portfolio, specifically how often the entire portfolio changes from one investment to another.
If an investment portfolio ended a year with a completely different set of investments to the beginning of the year, it churned at least once.
Why is portfolio churn bad for clients?
The reasons why portfolio churn is bad can be condensed into two points:
- If an investment is sound, it shouldn’t need changing
- Each change triggers fees, which reduces portfolio value
These two points standalone, but together they paint a bleak picture for any investor who experiences high churn levels in their portfolio. If their portfolio is being managed by a financial adviser or financial planner, this could reflect poorly on their services.
Churn shouldn’t be necessary
Unless you’ve signed up to a special ‘day trading’ service or want your assets to be managed like a high frequency trading hedge fund, then it’s likely that you want your adviser to create a sensible portfolio which works for the long term.
If this is the case, and your adviser has planned properly, then they shouldn’t need to change the make-up of your portfolio on a regular basis. After all, why would an investment made 12 months ago become ‘out of date’. Some people buy shares intending to hold them for life, so why can your adviser not seem to pick an investment which apparently sours after several months?
Churn is expensive
The stinging underbelly of portfolio churn is the fees and costs this creates. Not only do your old positions need selling, but your new positions need buying. Transaction costs like these can often eat 3-4% of your investment value. Therefore if you churn your portfolio once per year, this would reduce your returns by 4% each and every year. That pretty much eats into the entire premium you should expect to receive for investing in stocks rather than bonds.
This strategy leaves you with all the risk of owning stocks and shares, but undermines your return. With your returns being kneecapped in such a way, it’s very unlikely that you are returning enough to compensate you for the risk. Therefore you could experience a poor performing AND volatile portfolio – the worst of all cases.
Why do investment managers churn portfolios?
The reason why investment managers and stockbrokers would churn their client’s portfolios was because this is how they could earn an income.
It sounds very critical to say this, but indeed for some professionals it was acceptable to overtrade to generate additional commission, so long as the client was aware of each trade and agreed to it.
This often meant your stockbroker would give you a ring and explain the ‘next hot thing’ was a best buy and you’d be silly to miss out. With your agreement, they would happily sell out your poorer performing investments (boo!) and buy this up-and-coming new investment (yay!). This wasn’t a difficult sell to clients who didn’t understand the long term impact of portfolio churn.
Fortunately, portfolio churn is less of a problem now than it used to be. For one, intermediaries can no longer collect commissions from funds for directing their client into an investment. This means that moving a client from fund to fund, triggering initial fee after initial fee, no longer generates income.
The incentives of the investment managers have essentially been aligned much more closely with the individual investor, which is a powerful and subtle way to change behaviour.