A common term used to describe mutual funds is "turnover ratio." But what does that mean? And how can it help you when you are investing?
Lots of statistics and measures can help you learn about mutual funds. Many of them can help you decide whether or not to add a fund to your portfolio. Others aren't necessary for investing success. Knowing a mutual fund's turnover ratio, though, can reveal some important things about where that fund might be heading. This can include its potential future performance and taxation.
- The turnover ratio shows the percentage of a mutual fund's holdings that have been replaced during the previous year.
- Lower turnover ratios often mean lower costs and higher returns.
- Higher turnover ratios often mean the fund is more actively managed, which leads to higher costs and taxes.
- Average turnover ratios vary by type of mutual fund, so you should compare similar types of funds when evaluating ratios.
What Is a Mutual Fund Turnover Ratio?
The turnover ratio of a mutual fund shows what percentage of a fund's holdings have been replaced (turned over) during the previous year. This tells you how often a fund drops some assets and chooses new ones. Suppose a mutual fund invests in 100 stocks, and 50 of them are replaced over the course of one year. In that case, the turnover ratio would be 50%.
What Does a High Turnover Ratio Mean?
Most often, a fund with a higher turnover will have higher trading costs. This is measured by its expense ratio. The fund will also have higher tax costs than a fund with a lower turnover.
Why do funds with high turnover cost more? More trades result from more research and analysis. This takes more time and is more costly. Trades often have their own transaction fees as well. High turnover is most common with actively managed mutual funds.
What Does a Low Turnover Ratio Mean?
A low turnover ratio means that a fund is mostly sticking with the same stocks. For an actively managed fund, this could mean the fund manager uses a buy-and-hold strategy. A low turnover ratio, though, happens most often with passively managed funds. These could be index funds or exchange-traded funds (ETFs). Lower turnover often means higher net returns.
Funds with low turnover take less time to run, which means lower costs to run the mutual fund. These cost savings can be passed on to you. The higher tax costs mostly come from capital gains distributions. These are taxes from the mutual fund manager who is selling securities within the portfolio that have made gains. The taxes are also passed along to you.
What Are Good Turnover Levels?
Turnover ratios vary with the type of fund you are looking at. Some mutual fund types or categories of funds, such as bond funds and small-cap stock funds, will have relatively high turnover. This could be up to 100% or more. Other funds, such as index funds, will have lower turnover when they're compared to other types of funds. Their turnover could be 10% or lower. For all types of mutual funds, a low turnover ratio is often 20% to 30%. A high turnover ratio is above 50%.
Index funds and most ETFs often have turnover ratios lower than 5%. But the best way to determine ideal turnover for a given mutual fund type is to compare it to other funds of the same type. Then you might want to choose funds with a below-average turnover ratio, so they cost you less. If the average small-cap stock fund has a turnover ratio of 90%, for example, you may choose to find small-cap funds with turnovers below that average mark.
When Should You Use the Turnover Ratio?
A fund's turnover ratio can tell you important things about how a fund is run. It can also help you decide if it will cost more or less to invest in that other funds of the same type. But the turnover ratio alone can't tell you if you should invest in a single mutual fund or not.
As with many metrics used for analyzing mutual funds, turnover gives you just a part of the whole picture about a fund. You should always research and analyze other measures of a fund before deciding where to invest your money.