Every year in January, I do a big portfolio review. I rebalance my portfolio and make sure that I still like my current mutual funds and ETFs. And I get to know the turnover ratio for each mutual fund.
Why do I look at this ratio? It tells you how frequently a fund manager is trading.
That's a crucial piece of information because every trade costs you money. These trades can drive your hidden expenses. In short, more fees mean less return for you.
Let's look at how the mutual fund
turnover ratio is calculated and how this ratio will
help save you money
Turnover Ratio Calculation
The turnover ratio is a percentage of the assets that change each year within the fund. It is determined by taking either the total of the securities purchased or the amount of securities that are sold (whichever is a smaller amount) and dividing that by the assets.
Looking at it another way, a ratio of 50% says that, on average, the fund
is holding a stock
for two years. If the turnover ratio is 100%, then in theory, the portfolio is completely new every year. The higher the number, the more active trading the fund
Here's why a high turnover ratio costs money.
Every time a manager makes a trade, your costs go up because of higher commissions. This cost is not included in your annual operating expense
, so it increases your costs overall. Frequent transactions mean
out of your pocket.
Every time a mutual fund
sells a holding, it creates either a profit
or a loss. All profits
from the sale of the asset
are then passed along to you to pay taxes
. If your mutual fund
is in a tax-protected account, such as an IRA
, you don’t need to worry about this extra investment
On the other hand, if you own the mutual fund in a taxable account, you will pay taxes on the profit at the end of the year -- even if you have not sold any of your shares in the mutual fund.
Moving The Market
If the mutual fund is selling a large enough position, it can drive the asset price lower. This means the fund gets less money for the shares that are sold. Likewise if the fund buys a large enough position, the price may increase, thus causing the fund to pay more for the asset.
Problems With The Turnover Ratio
There are two situations in which the turnover ratio may be inaccurate:
- If the fund increased its assets and the rate of trading has not changed, the ratio will decrease because the assets are higher.
- Likewise, if the fund decreases in assets, the ratio will move higher because there are fewer assets in the fund.
The Investing Answer:
The best way to keep your costs down, other than a low expense ratio
, is to invest in a fund
that has low turnover. But what is a good ratio to target? Your typical buy-and-hold
strategy is going to have a ratio of about 25%. A domestic index fund
is typically going to be under 5%.
Personally, most of my funds
have turnover ratios of about 20% for actively managed and about 3% for index funds
. I hate fees and know that they can kill
your performance quickly, so I like to keep funds
that are doing very little trading.