What is the Turnover Ratio
The turnover ratio is the percentage of a mutual fund or other investment's holdings that have been replaced in a given year, which varies by the type of mutual fund, its investment objective and/or the portfolio manager's investing style. For example, a stock index fund will have a low turnover rate, but a bond fund will have high turnover because active trading is an inherent quality of bond investments; likewise, an aggressive small-cap growth stock fund will generally experience higher turnover than a large-cap value stock fund. Also, the more portfolio turnover in a fund, the more likely it will generate short-term capital gains, which are taxable at an investor's ordinary income rate.
BREAKING DOWN Turnover Ratio
Actively managed mutual funds with a low turnover ratio show a buy and hold strategy. For example, a mutual fund investing in 100 stocks and replacing 50 stocks during one year has a turnover ratio of 50%. However, because the average turnover rate of managed mutual funds is approximately 85%, nearly all of the funds’ holdings are being turned over annually. Some funds hold their stock for less than twelve months, meaning their turnover ratios exceed 100%.
Importance of Knowing Turnover Ratio
Knowing the historical turnover of a mutual fund helps an investor determine the fund’s expected performance in the future. Some funds such as bond funds and small-cap stock funds have naturally high turnover ratios. A high turnover results in increased costs for the fund and decreased returns for shareholders due to shareholders paying spreads and commissions when buying and selling stocks. In addition, funds with higher turnover ratios distribute yearly capital gains on which shareholders pay taxes, which lowers shareholders’ returns. In contrast, a low turnover results in decreased costs for the fund and increased returns for shareholders. Also, funds with lower turnover ratios distribute fewer capital gains on which shareholders pay taxes. Therefore, investors are advised to choose mutual funds with turnover ratios under 50% or index funds with turnover no greater than 5%.
If a portfolio's turnover ratio exceeds 100%, it should not be inferred that all of the stocks have been replaced, however. The ratio seeks to reflect the proportion of stocks that have changed in the recent year.
Example of Turnover Ratios
The Dreyfus Appreciation fund has a strong buy-and-hold method of investing in mostly large blue chip companies with total market capitalizations of over $5 billion at the time of purchase. Those companies show sustained profitability, strong balance sheets, global expansion and above-average earnings growth. As of March 2018, the Dreyfus fund’s turnover ratio was 4%.
In contrast, the Rydex S&P Small-Cap 600 Pure Growth fund invests in the common stock of companies within the capitalization range of the underlying index and derivative instruments. At least 80% of the fund’s net assets, as well as borrowings for investments, are invested in securities of companies in the underlying index and derivatives, and other securities whose performance should correspond to that of the underlying index. The Rydex fund is non-diversified and as of March 2018, had an average turnover ratio of 818%.