Mutual Funds Explained: Why Portfolio Turnover Matters

I discuss in my book, Mutual Funds for the Utterly Confused (McGraw-Hill 2008), the differences between the various expenses that impact an investors interest and return in a mutual fund. Among the sneakiest of these fees, is the turnover ratio. Why do investors still use funds that consistently report high turnover of the stocks in the fund's portfolio can be answered two ways. But first, what is a turnover ratio and how is it determined?

The Turnover Ratio is the result of the fund manager repositioning the portfolio. This is done much more often in a growth fund, where the manager may be looking for fund appreciation and to take advantage of this, they must sell some of what they hold in order to buy stocks that they feel will benefit their shareholders.

To determine the ratio on your own, investors will need to divide the value of both the purchase and sale transactions for the period by two and then, divide that figure by the total holdings of the fund. The higher the trading activity, which usually takes place in a growth fund more than in a value fund, the higher the turnover ratio.

If the turnover ratio is 100%, the fund has changed the underlying portfolio completely over the given the period. Less than 100% turnover, the fund's expenses for trading are lower than a fund that has exceed that number. Questions is: why would a fund manager trade so much if they knew that the cost of this activity creates a tax implication (in a retirement account, this tax consequence is deferred until you actually begin to draw on the funds)?

There are several reasons. New managers, of which there are many new faces in the mutual fund world after 2008, like to find better opportunities than their predecessors. Older managers may be attempting to restructure their portfolio to take advantage of newer opportunities that would redeem their fund's less than stellar performance during the height of the downturn. neither of these reasons though are very good.

You pay for research and subscribe to a charter (what your fund's investment focus is) and expect your fund manager to use these costs wisely. A high turnover ratio basically puts the spotlight on poor decisions followed by poorer, more costly revisions of those decisions. The higher the turnover, the more these managers have ignored research offered by their fund family or found that what you already paid for was somehow flawed. The higher the turnover ratio, the greater the resemblance a fund manager has to a day trader.

Even in a growth fund, these costs can be kept down and thoughtful and prudent trading can help a great deal. Believe it or not, there is a limited number of stocks available at any one time. To buy, you need a seller. As all investors know, the seller must know something that the buyer does not. In the small-cap arena, the number of stocks is much smaller because of liquidity (the number of shares available at any one time). Too few shares means that nay activity will drive the price up on the share price, create unnecessary costs, and in many instances, void any potential the stock might have in the near future.

This doesn't mean you should run for an index fund or even a value fund just because of fees. It does pay to consider them though and whether the fund's performance will be great enough to overcome the higher costs.

In a fund held outside of a retirement account, turnover ratios are essentially a taxable event (selling something profitable always creates taxes) and this is often taxed at the short-term rate. If you are using growth fund in your retirement portfolio (and I highly recommend that this is where they should be held) this tax is deferred. But that is not a reason to hold a fund that turns over its portfolio too much in any given period. For a growth fund, the portfolio turnover should not exceed 50-75%. If it exceeds this, something might be wrong.

Be sure to check out our all important examination of why investors do what they do.