In the last post, we showed how just the tax efficiency of low turnover buy and hold strategies can make your portfolio outperform. This occurs even if the pre-tax return is the same between short and long term trading strategies. Now we are going to examine how very low turnover in your portfolio can cause outperformance even excluding the tax considerations.
Let’s examine one of the most common indices on which index funds are based, the S&P500. The S&P500 has a rather arbitrary set of rules and processes for which companies it includes and which companies it kicks out. Due to this, the typical annual turnover of the S&P500 is 4.4%. This means every year, roughly 22 of the companies must be sold and 22 new ones bought. After 20-25 years, you will have turned over 80-90% of your holdings due to this.
Many of the companies that get kicked out go on to have excellent performance and are then included again at a later date after a large run up in performance! And a good chunk of the companies that are newly included are fads that eventually fail. As Jeremy Siegel showed, by buying and holding the original S&P500 members from 1957, you would have over time absolutely trounced the ever changing S&P500 index which was allowed to switch out companies. He estimates the extra return was anywhere from 0.55 – 1.29% depending on how the original portfolio was consituted. And the best part is, this doesn’t even include the additional improvement you would have seen due to the extra drag of incurred capital gains taxes on the “normal” S&P500 index. This is not just limited to the S&P500, either. The Ghost ship portfolio, which was constructed from the members of the Dow Jones Index in 1935 and held without ever selling except in rare circumstances, also absolutely trounced the return of the standard Dow Jones Index. Doing a rough calculation, the ghost ship portfolio appears to have outperformed the Dow Jones index by an average of 1.3% annually.
These two aspects of turnover for index investing (additional tax drag and performance drag) are a huge component of why I advocate for building your own star list of outstanding companies and investing in the ones that go on sale. You want to buy and hold these businesses and ideally never have to sell them (as Warren Buffett says, the ideal holding period for a company is forever). If you build a list with only tried-and-true companies that have shown the ability to earn durable and sustainable returns on capital, with outstanding balance sheets, good management, and otherwise good situations, you will decrease the chance that these companies will fail or perform poorly over very long periods of time. By buying the best-valued of these companies available at the time, you ensure that you don’t overpay and get the best deal you can for your money by purchasing the most cash flow for the least amount of money. By holding indefinitely, you decrease turnover and capital gains taxes, allowing your money to compound far more than in an index fund. These headwinds all align to give you great returns over the long run vs. a standard index fund. You still get all of the benefits of an index fund, but you are simply constructing your own index for maximum control and flexibility.
By building your own index, you can also use equal weighted or value weighted strategies instead of being bound by the cap weighted index. Some rough calculations show that equal weighted indices, for example, outperform cap weighted indices by 0.8 – 1.6% over the long term. However, these require more active management and therefore have higher expense ratios. If you construct your own index of stocks that you mostly buy and don’t sell, a value weighted strategy is easy to implement at low cost, and you will on average get a substantial boost to return over the long term from a value weighted strategy.
Let’s do a rough calculation to see how much a long term portfolio of bought and never sold stocks can do against an index fund. Let’s assume that the S&P 500 index fund gives a return of 12%, while our equal or value weighted buy forever portfolio with zero turnover earns a return of either 12.55% or 13.6% based on the range of historical numbers we see from these types of portfolios discussed above. How much will we have after 50 years of investment, if we invest an initial $10,000 in these strategies? From the last post, in the case of an index fund without taxes or expenses, we saw that we earn $2.89 million after 50 years in such a strategy. If instead, we earn an extra 0.55% per year (12.55% total return per year), which is on the low end of what we can expect based on historical returns of extremely low turnover value or equal weighted portfolios, we will have $3.69 million after 50 years. What about in the case where we earn an additional 1.6% per year (13.6% per year total return)? The portfolio after 50 years has grown to $5.87 million, or more than double the higher turnover index fund portfolio!
And this doesn’t count the boost to returns that tax optimization gives. Based upon our look at the last post, we can expect anywhere from a 3-15% boost in after tax final portfolio value by using good tax optimization strategies. If we invest $10,000 in the S&P500 index, we would probably see the return reduced from $2.89 million to an after tax and expenses return of more like $2.4 million. There should be much less reduction in the after tax portfolio values for the portfolios with the tax optimized buy and hold forever strategies. Perfectly optimized strategies that utilize tax advanaged accounts maximally may even see no reduction in portfolio value due to taxes.
In case I still haven’t convinced you that low turnover is critical for your long term returns, I will leave you with one final piece of data. Fidelity did a study in 2014 on their customers’ 401k accounts, which showed that the best performing group of investors were those that had died, and where the portfolio had remained untouched for a substantial period of time. The next best group of investors in terms of performance were those that had forgotten they even had investments with Fidelity. Low turnover really does matter to your long term returns. So, make sure that as you implement your investment strategy that you keep your turnover extremely low and practice buy and hold investing.
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