This version has been expanded to include more discussion of Lord Abbett's portfolios.
Lord Abbett Developing Growth, a big fund that buys small stocks, is dazzling. Its rapid-fire trading has it magically buying into hot stocks and then getting out before they cool. It was up 48% over the 12 months through mid-March. It gets five out of five stars from Morningstar.
It's a tempting product, but there's a problem with it. It's expensive.
Developing Growth, like all funds that quickly turn over their portfolios, is costly in a way that is not obvious when you look at the prospectus. The prospectus tells you about the 1.1% annual expense burden (low, at least compared with other actively managed funds) and the 5.75% sales load. But it doesn't spell out another item that in the long run matters much more: the cost of trading.
How much is that? You can't put a precise number on the damage from getting into and out of positions. But statistical evidence says that trading is a big hidden cost at funds that specialize in the stocks of small companies.
Trading will cost you brokerage commissions and bid/ask spreads. A third item is at once the biggest and the hardest to measure: the tendency for trades to push a stock's price away. You won't feel this effect when you sell 1,000 shares of IBM. You definitely would feel it if you tried to unload 500,000 shares of a little company.
Developing Growth's problem is its very success. It has attracted $4 billion of customers' money, and since it invests in small companies it winds up with large percentages of them. Among its 124 holdings is $69 million worth of LifeLock, a fast-growing firm that sells an ID theft alert service. That's 6.7% of the float (shares available for trading).
What's going to happen when the fund unwinds this unwieldy stake? That will depend on a lot of things, like how quickly the portfolio managers make their exit and whether there happen to be bulls at that moment on the sidelines, ready to buy on a price dip.
For any one buy or sell order, then, the push-away effect is unknowable. But it is quite possible to look at hundreds of funds doing thousands of trades and come to some conclusions.
Gregory Kadlec, a finance professor at Virginia Tech, has been studying mutual fund costs for 16 years. In a study published last year in the Financial Analysts Journal, he and two other academics derived trading cost estimates by analyzing returns for 1,758 funds over a 12-year period ending in 2006.
Some skillful (or just lucky) funds beat the market and some fall behind. Collectively they do worse than the market, Kadlec says, the shortfall reflecting both the expense ratios and the invisible loss from trading.
On average, the analysis showed, small-company funds lose 1.5% when they go into or out of something and recoup a bit more than half the loss with portfolio improvement. A fund with 100% turnover in its portfolio stands to lose 1.2% a year to trading.
Turnover at the Lord Abbett fund has been running 200% and higher, suggesting a trading-cost headwind of 2.4%. That's how much it would lose to turnover if its managers were merely average in their ability to replace one stock in their portfolio with a better stock.
Lately they have been rather better than average; the fund clearly did better over the past year than it would have if it had stood pat with its positions. This is a momentum portfolio, one that aims to catch upswings after companies deliver pleasant surprises with their earnings or revenues and then get out when the mood turns sour.
Thomas O'Halloran, the fund's lead manager, explains the trading philosophy used here and a sister fund buying larger companies, Lord Abbett Growth Leaders: "It's like a physics concept. Mass times acceleration equals force." Lord Abbett has worked this concept well in the bull market, getting in and out of stocks like Crocs, Open Table and Facebook in reaction to Wall Street's emotions. Growth Leaders' turnover is an even more ferocious 451%, Morningstar reports. It has also been beating the market.
Developing Growth owns, besides LifeLock, Hain Celestial, which has exploited the health food fad, and Generac, which sells back-up generators to fretful suburbanites. Such stocks do well in a bull market. What about a full cycle of up and down? The cost of trading is bound to hurt over time.