Investment Fund Turnover: Good or Bad?

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There are many types of turnover. In business, there are accounts receivable, inventory, and employee turnover. But there’s also investment turnover.

Investment turnover measures the percentage of an investment portfolio sold in a specific period. But what is an acceptable turnover ratio, and why is it important? Is a high turnover ratio better than a low one, or does it cost more? Knowing how to calculate a turnover ratio is invaluable.

Knowing the Portfolio’s Turnover Ratio

In investing, the turnover ratio is the percentage of mutual funds or other portfolio holdings that have been replaced yearly.

Some portfolio funds are held for less than 12 months. This means their turnover ratios exceed 100 percent. But that doesn’t necessarily mean that all the holdings have been replaced. The ratio reflects the proportion of holdings that change per year.

Turnover rates vary by three factors. These are:

• portfolio manager’s investment style
• type of mutual fund portfolio
• investment objective

A high turnover rate may result from an actively managed mutual fund. At the same time, a low turnover ratio may reflect a passive or buy-and-hold strategy.

The type of fund, like a stock market index fund, will have a low turnover rate. That’s because it duplicates a particular index. It replaces holding only when there’s a change in the index.

A large-cap value stock fund will experience lower turnover than an aggressive small-cap growth stock fund.

Computing and Reading a Turnover Ratio

Keep in mind that the turnover ratio is an approximate number. Many funds hold onto a large portion of the holdings for many years. Any activity may be focused on a small or moderate percentage of the portfolio.

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So, you wouldn’t want to state the fund changes all of its positions once every so-and-so years. Instead, a more correct explanation is a certain portion of the assets are traded “frequently.” Most of the other assets are held for several years.

For example, a mutual fund may have $500 million in assets at the start of the year. At the end of the year, it has $600 million in assets. It can be assumed the average assets are $550 million.

The fund managers bought $200 million in securities throughout the year and sold $150 million. In this case, you take the lower of the two values.

The formula for the turnover ratio is: ($150 million/$550 million)*100 = 27.27 percent.

This estimates that the mutual fund replaces about 27.27 percent of its assets that year. This is a low turnover ratio. You can infer the managers employ a buy-and-hold strategy.

Average Turnover Ratio

Although a fund’s ratio shouldn’t be the sole basis for investing or devesting, it should be noted. It can be helpful to compare the fund you’re interested in with other funds’ turnover ratios.

The average turnover ratio for a managed mutual fund is 75–115 percent. If you are a conservative-thinking equity investor, you might want to see a 50 percent turnover ratio.

Watching the average turnover ratio of your mutual fund can let you know if there is a change in management philosophy. For example, If a fund in a particular sector has a five percent turnover ratio one year and a 30 percent the next, you might want to know why. There might have been a change in the fund’s objective. Is it the same objective as yours? Or perhaps a new portfolio manager came in and decided to wipe the slate clean. Either way, it’s right to question.

Is High or Low Investment Turnover Ratio Better?

A high turnover ratio isn’t necessarily bad. The same goes for a low turnover. It’s important, however, to be aware of the consequences of turnover frequency.

A low turnover ratio can be beneficial depending on the investor’s goals. This strategy will often improve a client’s odds of long-term solid performance. It’s a buy-them-and-hold-them mentality. Managers who keep the turnover ratio low often practice low-risk strategies. But it could also indicate a passive fund manager.

A high turnover ratio increases the fund’s costs due to the payment of spreads and commissions. These costs could be reflected in the fund’s return. But on the other hand, it does indicate an active, engaged fund manager who is maneuvering to increase the funds’ assets.

But, there are tax implications to a high turnover ratio.

Portfolio Turnover and Taxes

Higher portfolio turnover or high ratio may generate short-term capital gains. These are profits on holdings held for less than one year and are taxable. They are taxed at an investor’s ordinary income rate. This is often higher than the capital gains rate.

Synopsis of Reading Investment Turnover

Although a turnover ratio alone won’t help you choose the “right” mutual fund, it can tell you the percentage of stocks and other assets replaced yearly.

It’s best to look not only at the turnover ratio but the fund’s overall performance. Ensure the fund reflects your investment mentality.

Finally, always consult an investment advisor with questions or concerns.

The Epoch Times copyright © 2024. The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.