Just like Football, high turnover is bad for you and good for the other team. Investing in mutual funds and exchange-traded funds (ETF’s) with high turnover ratios involves paying a substantial amount in transaction fees and other costs. This means these investments are at a performance disadvantage, and they could cost you money in other ways.
Defining High Turnover Ratio
What is Turnover Ratio?
Turnover ratio is the gross proceeds from all sales in an investment portfolio or investment fund, divided by the total assets in the exchange-traded fund or mutual fund.
For example, a 100% turnover ratio means the fund has sold its entire portfolio in a 12-month period.
What Constitutes a High Turnover Ratio?
So, at what point is a fund considered to have a high turnover ratio?
By percentage, turnover ratios can range from the low double digits to 100% or higher. There is no magic line at which a fund is declared to be high turnover, but low ratios like 30% are considered low turnover, while high turnover funds approach 100% and beyond, indicating that the typical holding is being turned over at least once per year. That will bring all of the negatives in the last section into the picture.
How to Determine Your Funds Turnover Ratios?
Many financial sites, such as MarketWatch and Yahoo! Finance, show turnover ratio.
Why Worry about High Turnover Ratios
There are three primary reasons an investor should be concerned with high turnover ratios in some funds:
High Transaction Fees
The more a fund trades, the more you’re being charged in transaction fees. Though it may represent a small percentage of the fund — one percent or less — that slight reduction each year cuts into your return, especially in the long-term. A one percent difference in transaction fees can add up.
Consider that $10,000 invested at 10% will grow to $25,937 after ten years. But when the return drops to 9% — after deducting 1% for transaction fees — the value after ten years will be $23,579. That’s a difference of $2,358 over ten years, which is equal to more than 23% of the original amount invested.
More Short-Term Capital Gains
Long-term capital gains are one of the most significant benefits to the stock market investor. Under current tax law, if your marginal income tax bracket is 12% or below, your capital gains rate will be zero.
If your marginal tax bracket is higher than 12%, your capital gains tax rate will be 15%.
But that’s only for long-term capital gains. Short-term capital gains — gains on securities held for one year or less — are taxed at your regular marginal income tax rates. The more of your capital gains that are short-term, the more you’ll pay in taxes on your investment returns. High turnover ratios mean more short-term capital gains.
High Cash Balances
Since high turnover ratio funds do a lot of buying and selling of stocks, they need to keep larger cash balances to make trades. Cash is money that isn’t invested! If your fund holds a lot of cash, say five percent, that means that only 95% of your invested capital is actually working to earn higher returns. Cash is a necessary part of a balanced portfolio, and you should have some at all times. But you don’t want to have large cash balances sitting in funds that are supposed to be invested for high growth.
Turnover ratios aren’t the biggest factor in investing success, but they do have a major effect on your returns, especially over the long-run. As such, it is a good idea to keep an eye on your funds turnover ratio and exchange high turnover ones for low turnover alternatives (as you would do with high expense ratio funds).