Turnover Ratios Weak Indicator Of Fund Quality

Mutual fund turnover is calculated as the value of all transactions (buying, selling) divided by two, then divided by a fund's total holdings. In simpler terms, mutual fund turnover typically measures the replacement of holdings in a mutual fund, and is commonly presented to investors as a percentage over a one year period. If a fund has 100% turnover, the fund replaces all of its holdings over a 12-month period.

You may discover that your mutual fund turnover rate is much higher than you expect. According to William Harding, an analyst with Morningstar, the average turnover ratio for managed domestic stock funds is 130%. Keep in mind that analysts typically disagree on most issues. Nonetheless, it is important for you to consider the turnover ratio before making any new investment decisions or maintaining your current investments. (Learn which fund manager investment style fits your portfolio, read Mutual Fund Management: Team Players Or All-Stars?)

As is the case with most technical indicators, the value of turnover in your mutual fund is not a litmus test for making an investment decision or an indication of future results. Perhaps investors should consider other factors in the context of your mutual fund's turnover rate before making a final decision. (If you want to learn more about how mutual funds work, read our tutorial on Mutual Funds.)

Value Funds
In general, value funds tend to have lower turnover rates, just by the nature of their investment philosophy: find undervalued securities relative to the market and hold them until they appreciate to a targeted value, then sell for a respectable gain. Fundamentally, this is a prudent approach, and helps minimize your funds taxable events and expense ratios. Fewer transactions imply lower trading costs and less short-term capital gains. But only investing in those funds with low turnover rate is not an investment strategy, and is no excuse for poor performance.

Many investors and money managers who espoused this buy-and-hold, low turnover approach have seen disappointing results. This is particularly true for those who recently saw "value" in financial stocks. Buying them on the cheap and holding them for a long period may have seemed prudent at the time, but, as the chart below illustrates, some mutual funds (notice the high proportion of specialty-financial funds) with low turnovers rates have underperformed the S&P 500 Index over a five-year period.

Symbol Fund Name Category Turnover (%) Annualized 5 Yr Return (%)
IFSAX AIM Financial Services A Specialty-Financial 15 -5.7
IFSBX AIM Financial Services B Specialty-Financial 15 -6.36
IFSCX AIM Financial Services C Specialty-Financial 15 -6.4
FSFSX AIM Financial Services Inv Specialty-Financial 15 -5.68
LCBBX AIM Large Cap Basic Value B Large Blend 29 -0.18
LCBCX AIM Large Cap Basic Value C Large Blend 29 -0.18
EUEYX Alpine U.S. Real Estate Equity Specialty-Real Estate 49 -0.21
CFIMX Clipper Large Blend 25 -1.73
FSVLX Fidelity Select Home Finance Specialty-Financial 36 -15.55
FEFPX Frontier MicroCap Small Blend 18 -22.48
Source: Yahoo! Finance

Growth Funds
Growth funds, on the other hand, tend to have a higher turnover rate because, in general, money managers are constantly looking for sectors and securities that are the next leaders in their respective industries. As implied above, a higher turnover rate means the fund will incur more taxable events, and that is likely to eat into the fund's total return. So, in a way, high turnover funds really must outperform value funds if all else is equal.

As is the case with value funds, the high turnover rate should only be justified with a high investment return. Unfortunately, many fund managers appear to be day-trading in disguise. The chart below shows some high turnover funds with lackluster five-year returns all of which lag the S&P 500 Index benchmark.

Symbol Mutual Fund Name Turnover (%) Annualized 5 Yr Return (%)
RYWCX Rydex Small Cap Growth C 834 -8.75
RYGRX Rydex Large Cap Growth C 450 -10.59
AFUAX AFBA 5Star Cap Growth Adv 254 -7.27
AFGLX AFBA 5Star Large Cap Growth I 254 -7.05
VCGAX AIG Retirement I Growth & Income 238 -6.97
GSXAX Aberdeen Small Cap A 215 -4.42
Source: Yahoo! Finance

Another consideration for investors when evaluating mutual fund turnover is the type of investment accounts in which the funds are located. Non-retirement accounts are more likely to incur taxable events, and therefore funds with low turnover rates may be more appropriate. Retirement accounts with tax-deferred (401k) or tax-free status (Roth IRA) may be more appropriate for mutual funds with high turnover rates. In any case, investors should do their homework to determine which is the right mix for them.

There are many online sources for finding turnover rates of a particular fund. Yahoo! Finance, Morningstar, WSJ.com and many others provide mutual fund turnover data on almost all mutual funds. Some websites also list the category (type of fund) average turnover rate for the fund.

The turnover rate in your mutual fund is really a measure of the frequency of transactions in your funds. In general, investors should analyze the turnover rate in conjunction with several considerations in determining whether or not to purchase a particular mutual fund. The fund turnover rate is not a silver bullet for your investment portfolio; it should be used as a complimentary decision-making tool. Other indicators, such as expense ratios, load/no-load, management tenure, investment philosophy and performance are (at least) as important as the turnover rate in helping you make the right investment decisions. (For more information on choosing the right mutual fund for your portfolio, read our article Picking The Right Mutual Fund.)