Turnover is a term you’ll often hear when people talk about mutual funds and ETFs. What does it mean and is it important?

What Is Turnover?

Turnover refers to the number of times a portfolio is bought or sold during a year. Investors look at that number because it helps them understand how frequently the manager is trading. That’s important because higher trading can lead to riskier investment style, higher trading costs and increase your tax liability all at the same time.

The fund company calculates turnover by looking at the total dollar value of new share purchases and the total value of sales. They take whichever number is lower and divide it by the Net Asset Value (NAV) of the fund to determine the turnover ratio. Let’s look at an example to see how easy this really is.

Let’s say we look at fund XYZ and determine that the value of all its holdings is $100,000,000 as of 12/31/14. We also see that during the year it sold $25,000,000 of its portfolio and replaced those sells with $25,000,000 of new purchases. That totals to $50 million. We take that number and divide it by $100 million and determine that the turnover ratio is 50%.

Why This Matters

All things being equal, the greater the turnover the more it costs the investor. Every time a fund manager buys and sells a stock he or she has to pay a commission of course. But those aren’t the only costs involved.

Remember that mutual funds often hold hundreds of thousands of shares of any particular company. When they buy or sell those shares they could be moving a relatively high percentage of all the traded shares. If they flood the market with shares, prices drop. If they snap up a large percentage of available shares quickly, it drives share prices up. This is known as “slippage” and it can be expensive. It’s another cost of turnover.

Also, when a fund manager moves in and out of stocks quickly (pushing the turnover ratio up) that can generate short-term gains which are taxed at higher levels than long-term gains.

Last, if the turnover ratio is high it indicates the manager is blowing in and out of stocks very quickly. That can mean the fund is speculative and therefore a higher risk proposition.

When To Disregard Turnoverwhat is turnover

If you invest based on fund performance, turnover doesn’t matter. Yes, the costs are higher but performance is always reported after paying all expenses. And if you purchase funds based on performance that’s really all you should care about as long as the proposed fund is in the risk category you are comfortable with.

Need proof? Look at the best performing funds for any particular year. They are rarely those funds with the lowest cost. I’ve noticed that phenomenon for many years. It happens because outperformance can more than makes up for the higher costs of the fund.

How I Use Turnover

As you might have guessed, I buy funds based on performance so turnover isn’t critical to me. But if I have two funds with very similar performance I’ll take the fund with the lower turnover every time.

Still, I don’t use turnover as a primary criteria. In my opinion, if a fund manager demonstrates real performance, why should I care how much he or she trades?

Maybe you feel differently. What are your thoughts on portfolio turnover? Is it important?

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