The turnover ratio of a mutual fund is the degree to which the stocks or other investments held by the fund get sold or purchased over a period of time, usually a year.
Actively managed mutual funds choose from among the many hundreds of potential stocks or bonds, depending on their outlook for specific investments over time. The investment style of the fund also plays a role: One fund might favor value investments, while another might be focused on growth.
In contrast, an index fund or passive fund such as an index-tracking exchange-traded fund (ETF) would by design hold all of the stocks in a given index at specific weightings meant to replicate the index itself.
In the case of the actively managed fund, the turnover ration could be fairly high. So the fund holds 50 stocks. Over the course of a year the fund’s managers decide to sell 25 of those stocks in order to generate gains and then reinvest into 25 new stocks,
That would indicate a turnover ratio of 50%. While some funds are quite active and have a turnover ratio of 100% (ever position is replaced within a year), others are less so and might replace only 10% or 15% in a year.
The passive index fund, meanwhile, has virtually no turnover. It tries to own all of its constituent holdings uninterrupted. Some funds choose to replicate their index by sampling a representative portion of shares in the index, while others are large enough to actually own all of the stocks.
Is a high turnover ratio bad? It depends. If you buy a niche mutual fund that trades often you would expect a relative high turnover of positions. Likewise, an active stock mutual fund that largely follows the S&P 500 would be much lower, albeit not entirely passive.
The problem, if there is one, is that high turnover implies higher cost. As positions are sold that activity can generate costs through higher trading fees and commissions, which are passed on to investors. Likewise, in a taxable account gains are taxable at the investor’s income tax rate.
You would have to believe that the fund management’s choices will result in a return that’s higher than simply owning the index at a low cost through a passive index fund or ETF. Plus, that return must be higher after the costs of fees and taxes.
Before you buy a mutual fund, familiarize yourself with the turnover ratio under the current management team. Ask yourself if the turnover ratio seems reasonable for the fund’s objectives.
For instance, a fund that follows volatile but high-returning small company stocks might have a higher turnover ratio than a large-cap stock fund and even higher than a bond fund.
You can also compare the turnover ratios of similar funds to get a sense of the management’s approach to investing over at least the last 12 months. If you were investing the money directly, would that much trading unnerve you, or excite you about the prospect of higher gains.
A lot depends on your demeanor as an investor, and if you believe that the fund’s managers are making trades with a plan in mind or simply running from one bad investment toward another with no plan at all.
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