The Long and the Short: Portfolio Turnover Ratios & Mutual Fund Investment Time Horizons.

• Author: Tucker, Anne M.

1. INTRODUCTION II. PORTFOLIO TURNOVER RATIO: U.S. CALCULATION AND USES A. UCITS Alternative III. PORTFOLIO TURNOVER RATIO DATA IN PUBLIC DEBATES A. The Portfolio Turnover Ratio Signal Strength & Criticisms 1. Time Horizon & Transaction Cost Estimates 2. Common Critique: Strategy & Liquidity. 3. Common Critique: Round Trip Trades 4. Common Critique: Asset Classes & Rare Events 5. Common Critique: Tax-Specific Concerns B. PTR Uses 1. A Literature Review of PTR a. PTR in Legal Literature b. PTR as Investment Time Horizon Estimate c. PTR as a Transaction Cost Estimate d. Limitations of Portfolio Turnover Ratio Calculations e. Law & Policy 2. PTR in Finance Literature 3. PTR in U.S. Policy & Business Debates. a. U.S. Legislation & Policy. b. Business & Industry Reports IV. REMEASURING PORTFOLIO TURNOVER RATIOS A. PTR Data B. Mutual Fund Time Horizon PTR Re-measurement Methodology 1. Overview of Measure 2. General Portfolio Turnover Ratio Trends 3. Trends by Fund Cap & Style Codes C. Robustness Checks: Alternative Measures of Mutual Fund Investment Time Horizons 1. Duration Measure a. General Duration Trends b. Duration Trends by Style and Cap Codes 2. Churn Rate a. Churn Rate General Trends b. Churn Rate Trends by Fund Style & Cap Codes 3. Modified Turnover Rate a. General MT Trends b. MT Trends by Fund Style and Cap Codes V. DATA DISCUSSION A. Average Holding Periods PTR & Alternative Measures B. Signal Strength: Relationship Between PTR & Alternative Measures 1. Limitations of Empirical Observations C. Mutual Fund Turnover Report & Time Horizon Estimate Recommendations VI. CONCLUSION. VII. APPENDICES A. Appendix 1: Top 10 Public Companies by Market Capitalization & Top 10 Institutional Holders. B. Appendix 2: Count & Analysis of PTR in Literature C. Appendix 3: PTR Sources in the Congressional Record by Hearing & Date D. Appendix 4: Annual Mutual Fund Data by Measures & Years E. Appendix 5: PTR Mean Distributions by Measure and by Year F. Appendix 6: Correlation & Regression Data I. INTRODUCTION

   Mutual fund investment time horizons are central to the short-termism debate. (1) Short-termism is a general, negative diagnosis for an inappropriate and unjustified focus on short-term gains or earnings, usually measured in quarters, over long-term returns. (2) Using a unique dataset, this Article evaluates the investment time horizons of all U.S. registered mutual funds from 2005-2015 using the SEC reported metric of portfolio turnover ratios (PTR) and three alternative measures developed in the finance literature: Duration, Churn Rate, and Modified Portfolio Turnover. With this dataset, I contribute to two foundational inquiries. First, how long, on average, do mutual funds hold onto their assets? Second, how good of a measure is the PTR at approximating mutual fund holding patterns?

   As I demonstrate below, the assumption that mutual fund investor time horizons have been shortening during the past decade are incorrect. They are short--in the range of fifteen to seventeen months--but not shortening. Rather, mutual fund time horizons have remained relatively constant, between 2005 and 2015, with evidence of increased holding periods following the financial crisis. These findings are consistent across three of the four measures (3) and analyzed across different mutual fund market segments.

   Recent empirical data on mutual fund holding patterns add nuance to a common narrative attributing corporate short-term performance pressures to institutional investors, including mutual funds. (4) Scholars posit that institutional investors' narrow focus on quarterly earnings favors corporate actions with near-term benefits, regardless of long-term effect. (5) Institutional investor pressure, (6) particularly from mutual funds, can permeate and infect operating company time horizons. To illustrate the reach and depth of mutual fund holdings, see Appendix 1 summarizing the top unaffiliated holders of stock in the top-ten market capitalization, public companies. (7) Funds' quarterly earning preoccupation and anxiety may feed the quarterly anxiety of corporate boards of directors. Mutual fund short-termism may encourage corporate maneuvers to prop up short-term value, eroding long-term value-enhancing investments. (8) Short-termism is seen as a contagion that can spread from funds to firms.

   The short-termism debate is a subtext to discuss corporate control, governance norms, and the role of markets. (9) Scholars sympathetic to negative short-termism claims propose an antidote of increased corporate board control to insulate managers from the pressures of greedy, short-term orientated investors. (10) Opposing scholars highlight short-term investors' ability to unlock firm value and counter corporate management long-term bias, or myopia. Proponents draw from competitive market pricing efficiency theories so that long-term beneficial actions are priced into current prices as are value detracting time irrationalities like short-termism. (11) Promoting shareholder voting rights and activism is consistent with this view. (12) Identifying the cause or causes of an inappropriately short-term time horizon is necessary, and preliminary, to identifying any solutions.

   The short-termism debate is not purely academic. Legislators and practitioners have proposed legal and policy solutions reflective of the first narrative that institutional investors' short-termism negatively infects corporate management time horizons. (13) Mutual funds control $15.7 trillion in assets, own 31% of U.S. public companies, and are the primary retirement savings vehicle for 93 million Americans. (14) Mutual funds are major market participants; they influence operating companies; and, they are a foundation of our national retirement policy and individual financial security. (15) All mutual fund investors bear the direct costs of portfolio turnover through transaction fees like commissions and taxes. All mutual fund investors also bear the indirect costs of any negative market externalities generated by short termism. (16) If tomorrow's future is mortgaged for today's gain, this is a costly gamble for too many working Americans saving for retirement.

   Each of the preceding paragraphs implicate a rich and divisive body of literature that the footnotes cursorily address. For purposes of this Article, it does not matter whether you believe that short-term pressures within funds permeate into the operating company's consciousness or whether the funds' transferred time horizon encourages value reducing operating company decisions. This Article asks a more foundational question: what do we know about mutual fund time horizons and are they increasingly short-term? If so, the contagion narrative gains prominence and support. If not, the short-termism narrative lacks nuance and invites revision.

   Part II describes how all mutual funds report an indirect measure in their annual N-1A filing with the SEC--the portfolio turnover ratio (PTR). (17) For those unfamiliar with the PTR, it estimates what percentage of a mutual fund's portfolio assets (i.e., stocks) were bought or sold in the last year. The percentage of asset turnover roughly estimates how frequently a mutual fund replaces existing stock holdings with new holdings. For example, a turnover ratio of 20% can be used as an estimate that a mutual fund buys and sells 20% of its stock holdings each year, or in other words, holds each stock position, on average, for approximately five years. Critics of short-termism have co-opted the PTR, a measure originally constructed as a transaction cost estimator, as a signal of mutual fund investment time horizons.

   The portfolio turnover ratio, as a window into mutual fund time horizons, is criticized as an indirect measure that generates unreliable and inaccurate estimates--critiques explored in Part III. Flawed as the portfolio turnover ratio may be, however, it remains the only estimate that all funds calculate and that all funds report annually to the SEC. Part III catalogues how law, finance, and policy interpret portfolio turnover ratios and link the PTR to mutual fund time horizons.

   Four points are clear from the historical review in Part III. First, despite the criticisms levied against the PTR as a time horizon estimator, policy debates and legal scholarship cite to portfolio turnover ratios as evidence--often the only empirical evidence--to support the primary assertion that institutional investors are increasingly short-term and a contagion that infects the time horizons of operating company managers. Second, the empirical basis for short-termism claims is self-referential and dated. It can be traced back to John Bogle's work in the early 2000's. Third, finance literature engages with portfolio turnover ratios, but the work translates poorly to answer the questions of this Article: what do we know about mutual fund time horizons and the strength of the PTR signal? Finally, documenting the widespread use of and reliance on portfolio turnover ratios, and combining it with the absence of new data on the topic, justifies the empirical review undertaken in Part Iv.

   In Part Iv, I chart the portfolio turnover ratios of all open-ended, publically traded mutual funds from 2005-15 to observe trend lines and explore the central question of this Article : are mutual fund investment time horizons increasing or decreasing? (18) I expand my inquiry by borrowing from finance literature and computing three alternative measures of mutual fund holdings and portfolio turnover--Duration, Churn Rate, and Modified Turnover. (19) I compare the ten-year trends under each of those measures to the PTR calculations. In these two ways, I test whether portfolio turnover ratios are increasing (more short-termism) and the strength of the PTR signal as to mutual fund investment time horizons. My supporting hypothesis is that the PTR signal is reinforced if the alternative measures are correlated with...