Why should fund investors be concerned about portfolio turnover? There are four major reasons, and they all impact a fund's investment quality:
- There is an abundance of research that shows that buy-and-hold fund managers (low turnover) outperform their colleagues who trade frequently (high turnover). One of the reasons for this is that the former spend less on trading commissions than the latter. Trading costs are coming down, but they can still represent a significant fund expense.
- These trading costs are not included in a fund's expense ratio. Thus, transaction costs are often ignored by investors because they are buried as a dollar figure, as opposed to a percentage of assets, in a fund's Statement of Additional Information (SAI). It is likely that only a tiny fraction of mutual fund investors are even aware of this document, let alone familiar with its content. (To learn more, read Stop Paying High Fees.)
According to 2005 Lipper Services data, trading commissions add, on average, an additional 0.15% to fund expenses. While the percentages may seem small, it can significantly ding returns over time. For example, consider two hypothetical $10,000 investments over 20 years in different funds with nontrading (operational) expenses of 1%, one with trading costs of 0.5% and the other with trading costs of 1%. Assuming annual growth of 8%, an investor would end up with just under $34,500 in the first fund and about $31,100 in the second. The $3,400 difference represents a significant 11% bonus in return for fund No.1 over fund No.2.
- The components of an index fund change infrequently, which puts these types of funds in a low trading mode. However, unlike index funds, managed funds have human beings at the controls. And, the greater the number of trades, the more often the manager has to be making the right decision. A high volume of trading places a lot of pressure on managers to avoid making mistakes in investing judgments. (For related reading, see The Lowdown On Index Funds.)
- A high level of fund trading activity generally occasions a higher-than-average amount of capital gains. Mutual funds must pay out these gains as dividends to fund shareholders, which are then subject to capital gains taxes. For investors in taxable funds, i.e., not in tax-deferred accounts, high portfolio-turnover funds are not tax efficient.
The Benefits Of Low Turnover
A low portfolio turnover rate is a very positive fund investment quality. However, it must be remembered that the nature or investing style of a fund can impose certain "structural" features on portfolio management that influence its trading activities:
- Small-cap stock, international and growth funds tend to have higher turnover rates. These funds are more transaction-intensive as the managers maneuver for competitive advantages.
- Index funds should have low turnover rates, no matter what their category.
- Trading is a natural function of bond funds, which puts their turnover rates way up on the scale. (To learn more about this type of fund, see Evaluating Bond Funds: Keeping It Simple.)
- Funds that carry only a small number of securities in their portfolios oftentimes reflect high turnover rates because of the impact of a single trade on a major holding.
Return to the Main Menu.
Scoring Fund Turnover Data
Financial AdvisorPortfolio turnover measures a fund’s percentage of assets that are bought and sold by its manager over a year.
InvestingThis indicator is not as important as some investors might think.
InvestingA turnover ratio measures a mutual fund’s level of trading activity in a given time period, usually a year.
InvestingLearn about five important items found in a mutual fund's annual and quarterly reports and why investors should pay attention to changes in these items.
Financial AdvisorWhat to really look for when you're deciding on a mutual fund.
InvestingMutual funds are a good way to balance your asset allocation but there some potentially expensive pitfalls investors need to be aware of.
InvestingIt may be best to opt for ETFs over mutual funds, which allow wiser investors to reduce their tax obligations.
Financial AdvisorDiscover some of the basic characteristics shared by good mutual funds that investors can use to help them in selecting funds.
InvestingDiscover how investment strategies and expense ratios impact your mutual fund's returns.