Portfolio Turnover Metrics Can Red Flag Style-Drift, Excessive Trading

28 May 2014

This article first appeared on FINalternatives.

As the number of institutional investors adopting a more progressive stance toward portfolio management grows, assets are increasingly being allocated away from mutual fund-like strategies into hedge funds and other alternative investments. As this shift takes place, risk management has come to the forefront. Investment teams have needed to adopt new techniques to monitor whether or not these sophisticated strategies are working. While some of the risk and performance measures developed as part of classical portfolio management theory become obsolete and inadequate when applied to hedge funds, a few traditional metrics can still provide meaningful insights. One such metric that is common within the mutual fund space but underemphasized with hedge funds is the portfolio turnover ratio. In its simplest form, this ratio measures the propensity of a portfolio manager to roll over his/her investments by dividing the value of trades executed within a given period by the total portfolio value. When combined with other performance metrics and monitored over time, this measure can help to identify strategy deviations like style drift and identify potentially excessive trading activity that should be monitored. Hedge fund administrators, who have unobstructed visibility into a fund’s day-to-day activities, are well positioned to track and report on portfolio turnover statistics. In an attempt to better understand the behavior of this metric in the hedge fund context, Maples Fund Services has computed monthly turnover values for a sample of long-short equity hedge funds.

We identified four groups of portfolio turnover behavior:

  • Funds with range-bound turnover values that typically fall in the 10% to 40% band;
  • Funds with consistently high turnover values (>150%);
  • Funds with consistently low turnover values (<5%); and
  • Funds with highly volatile turnover values ranging between 1% and 250%.

While standards for portfolio turnover ratios apply less in the hedge fund context than they do for mutual funds, when funds were examined individually we found that historical turnover patterns can provide useful insights. By establishing a confidence interval in the form of a historical mean of a fund’s portfolio turnover ratio +/- 2 standard deviations, we can identify anomalies within periods. Applying the described approach to this long-short equity fund, we are able to quickly identify a portfolio turnover anomaly that occurred in Q2 of 2012. The portfolio turnover ratio provides simple, intuitive insight into a fund’s trading activities, and can supplement performance figures with transparency regarding how results were obtained. This knowledge becomes a starting point from which an investor can ask questions during due diligence meetings. Whether the explanations are compelling or not, active engagement of investment managers in dialogue about portfolio activity is an important element of any effective risk management program.

Tyler Kim is the Chief Information Officer for MaplesFS, responsible for Information Technology and Data Management globally. Iliya Goldverg is involved in the design and implementation of technological solutions to support the middle office and risk reporting needs of MaplesFS’ clients.

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