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.
Be sure to also see the 7 Questions to Ask When Buying a Mutual Fund
Why It Matters
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.
See also How Mutual Funds Are Taxed
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?
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.