How to Benefit From Using a Mutual Fund Turnover Ratio

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If you've done any research on mutual funds, you've likely seen a term called turnover ratio. But what exactly does the turnover ratio mean and how can investors use it to their advantage?

There are dozens of quantitative statistics and measures for analyzing mutual funds, some of which are not necessary for investing success. However, if you know a mutual fund's turnover ratio, it can reveal a few important aspects of the fund's potential in the future, including performance and taxation.

Mutual Fund Turnover Ratio Definition

The Turnover Ratio of a mutual fund is a measurement that expresses the percentage of a particular fund's holdings that have been replaced (turned over) during the previous year. For example, if a mutual fund invests in 100 different stocks and 50 of them are replaced throughout one year, the turnover ratio would be 50%.

What a Low Turnover Ratio Means

A low turnover ratio indicates a buy and hold strategy for actively-managed mutual funds, but it is naturally inherent to passively-managed funds, such as index funds and exchange traded funds (ETFs). In general, and all other things being equal, a fund with higher relative turnover will have higher trading costs (as measured by Expense Ratio) and higher tax costs, than a fund with lower turnover. It is because more trades generally result from more research and analysis, which has its own costs. Trades often have their own transaction fees as well.

In summary, lower turnover generally translates into higher net returns because it usually translates into lower relative costs to manage the mutual fund. Therefore the cost savings can be passed on to the mutual fund shareholders.

The higher tax costs mostly come from capital gains distributions, which are taxes generated from the mutual fund manager selling securities within the portfolio that have gained. These taxes are then passed along to the investor.

Best Turnover Levels Based Upon Mutual Fund Type

Some mutual fund types or categories of funds such as bond funds and small-cap stock funds will naturally have high relative turnover (up to 100% or more) while other fund types, such as index funds, will have lower relative turnover (less than 10%) compared to other fund categories.

Generally, for all types of mutual funds, a low turnover ratio is less than 20% to 30%, and high turnover 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 make an "apples to apples" comparison to other funds in the same category average. For example, if the average small-cap stock fund has a turnover ratio of 90%, you may choose to seek small-cap funds with turnovers significantly below that average mark.

As with many statistical metrics used for analyzing mutual funds, the turnover ratio cannot be used in isolation to determine the worthiness of any given mutual fund. Investors are wise to research and analyze other qualities quantitative measures of the fund.