There are many technical characteristics that reflect how a mutual fund is operated and its portfolio managed. Beta provides a measure of a fund’s volatility while alpha indicates how well the portfolio manager is doing compared to the fund’s benchmark index. However, a fund’s turnover ratio is often overlooked by less experienced investors when they evaluate a given fund. But this ratio can help investors and analysts to see how well a fund is following its stated investment objective.
As its name implies, the turnover ratio of a mutual fund is simply a quantification of the percentage of the securities held in the fund that were bought and sold during the year. The calculation for this ratio is fairly simple. Take the lesser of either the total number of securities that were bought or sold during the year and divide that number by the dollar amount of the fund’s average monthly assets during the year.
The higher the ratio, the higher the annual turnover is in the portfolio. A ratio of 100% or more shows that all of the securities that the fund held a year ago have since been sold and either replaced with other holdings or held in cash.
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Why It Matters
Portfolio turnover can impact a mutual fund’s overall performance in several ways. One of the most obvious effects of high turnover is from the corresponding increase in transaction costs. Mutual funds have to pay commissions on their buy and sell trades just like individual investors, and this expense lowers the returns posted by the fund in the same manner.
This is one of the reasons why index funds have become so popular, as many investors have come to realize that index funds have virtually no turnover and usually outperform the vast majority of managed funds over longer periods of time. Furthermore, commission costs are not included in the fund’s expense ratio that is listed in the prospectus; they are typically listed separately as a total dollar figure in the fund’s Statement of Additional Interest (SAI).
Lipper published a study several years ago that estimated the average mutual fund carries transaction expenses of about 0.15% per year-which can cost investors with larger share holdings thousands of dollars over time.
Another negative aspect of high portfolio turnover comes from the tax man. Higher turnover means a higher number of reportable gains and losses that are passed on to shareholders at the end of each year. This can be bad news for retail shareholders who do not hold their funds inside an IRA, employer-sponsored retirement plan or variable annuity contract. And in most cases, the gains that are posted will be short-term, since they were held for less than a year. This means that these gains will be taxed as ordinary income, and shareholders will be taxed at the rate equal to their highest marginal tax rate.
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Although taxes and expenses are certainly significant factors to consider when it comes to portfolio turnover, perhaps the most important measure that it provides is how well the fund is being run behind the scenes. There are several reasons why a fund might have high turnover, and in most cases none of them are particularly good. Some portfolio managers attempt to outperform the market through constant trading-which, as mentioned previously, seldom works over longer periods of time. In other cases portfolio managers realize that they have made poor choices and then must sell holdings and replace them with other picks in an attempt to recoup losses.
New portfolio managers that replace experienced ones also may choose to trade with greater frequency in an effort to distinguish themselves from their predecessors. A fund’s turnover ratio can in fact be an indicator of whether a fund is following the investment objective that is stated in its charter. For example, a fund that stresses tax efficiency that has a turnover ratio above 60% is probably not doing a very good job of minimizing taxes, unless the majority of sales were for the purpose of dumping losing picks-which, of course, is another bad sign.
What Types of Funds Are Prone to Turnover?
There are several types of funds that are more likely to have higher turnover ratios than others. Growth-oriented funds such as small cap and international funds often post more trades than the average fund. Sector funds that focus on areas such as healthcare, technology or energy also typically contain greater turnover than their more sedate counterparts. Bond funds that seek to bolster their returns with capital gains can also fall into this category.
Investors can find out more about a fund’s portfolio turnover from sources such as Morningstar and Value Line, both of which offer key information on this point. Be sure to compare the turnover ratio to other funds in its peer group, as a comparison between an aggressive growth fund and a well-run tax-managed fund would obviously have little meaning.
The Bottom Line
Although it is not listed in the fund prospectus, turnover ratio can have a substantial impact on a fund’s performance and tax liability, and those who ignore this factor may be forfeiting more money than they realize over time. For more information on the nature and impact of portfolio turnover in mutual funds, log onto Morningstar’s or Value Line’s websites or consult your financial advisor.