If you've done any research on mutual funds, you've likely seen the term "turnover ratio." But what exactly does that 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, including performance and taxation.
- The turnover ratio expresses the percentage of a mutual fund's holdings that have been replaced during the previous year.
- In general, a lower turnover ratio means lower costs and higher returns.
- Higher turnover ratios usually indicate more actively managed funds, which carry higher costs and taxes.
- Average turnover ratios vary by type of mutual fund, so you should compare similar types of funds when evaluating ratios.
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. The reason is that more trades generally result from more research and analysis, which have their 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 made gains. The 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%) as compared to other fund categories.
Generally, for all types of mutual funds, a low turnover ratio is 20% to 30%, and 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 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 quantitative measures of a fund.