One of the mantras of mutual fund investing is to look at a fund’s turnover before you buy it. The implication is that a high turnover is bad. (Turnover is the percentage of a funds holdings that are traded during a year. Funds can have a turnover greater than 100%, which means that their average holding period per investment is less than one year.) Many mutual fund screening tools have portfolio turnover as one of their filters and you can usually find a fund’s turnover (expressed as a percentage) on the fund’s snapshot page or by doing a little digging on the fund’s website.
Here’s the first argument as to why turnover is bad. Higher turnover results in higher expenses because of higher transaction costs. This is true both for stock and bond funds, although turnover is even more relevant for bond funds. Why? Transaction costs are greater and trading spreads are wider for bonds (except for US Treasuries) than for stocks. And, the upside potential of a bond or bond fund is limited, as compared to a stock or stock fund, particularly for short maturities and high quality, so transaction costs have a greater impact on returns.
Tax inefficiency is the second argument as to why an investor should avoid mutual funds with a high turnover. If you hold your mutual fund in a taxable account, rather than in a tax-deferred account such as a 401-K or IRA, the fund’s taxable gains (and losses) are taxed to you in the year they occur. The higher the turnover the greater the likelihood that these gains will be short-term and you will be taxed accordingly.
I’ll add my own reason to look at turnover. Just like the kid who couldn’t sit still in school, higher than average turnover might suggest a nervousness or lack of conviction on the part of the fund manager. Portfolio turnover varies by asset class. For example, small cap growth stock funds generally will have higher turnover than big cap value funds. So, turnover is somewhat relative. Some fund screeners allow you to sort for funds with turnover equal to the average for a particular fund type or you can look at the turnover ratios for funds within the same group and estimate what’s the norm. Unless your fund’s turnover is much greater than its peers, you shouldn’t worry.
High turnover is bad, right? Wrong. For two reasons. The turnover expense is part of a fund’s overall expense and all funds are required to disclose their expense ratios. (A fund’s expense ratio is another sort in most fund screens and appears in its snapshot, oftentimes very near its turnover.) Unless a fund creates a lot of unwanted taxable income for you, its total expenses are of greater concern than its turnover, and a fund’s expense ratio pales in importance when compared to its return. Once you’ve set your risk level, the best investment is the fund with the highest return, even if it has a higher turnover or higher expense ratio than its peers.
Return always comes first. Don’t forget its after-tax return. So buy mutual funds with the highest returns consistent with your risk level and investment objective, and consider putting those funds with high turnover in your tax-deferred account.
