Complete Guide To Investment Companies, Funds And REITs


Introduction - Turnover

In an investment portfolio, turnover refers to the number of shares traded in a given period. Expressed as a percentage, it tells us what portion of the securities (stocks, bonds or both) in a fund's portfolio are bought and sold during the course of a year.

The four major reasons investors should be concerned about turnover include:

  • 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.
  • 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.
  • 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.
  • 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.

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.
  • 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.

Whatever the category of mutual fund being considered, the lower the portfolio turnover percentage the better. While this measurement may vary from year to year, a fund's trading activity is within the control of the manager and should consistently fall, historically, within a reasonable range.

While this list of terms is by no means comprehensive, it does lay a foundation on which you can build your investment knowledge. To learn more, keep reading.

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