Keep An Eye On Turnover

Mutual fund investors need to be aware of money managers who are constantly buying and selling securities.

Constant upheaval can reduce returns several ways: It can add to operating costs because those trades mean higher commissions, push up income tax bills for many savers, and may even reduce long-term investment returns because it’s hard for a frantic trader to beat a buy-and-hold investor.

The measure of how much trading is going on is known as the “turnover rate” in the investment industry. Essentially, it measures how long it takes to replace all the stocks in a portfolio.

“Higher turnover results in trading costs, which, while not included in the fund’s expense ratio, come out of returns and compound over time,” said Alice Lowenstein, an analyst for the fund research company Morningstar in Chicago.

High turnover rates mean higher taxes to you, because when a fund profits from the sale of a stock, it passes those gains on to you.

Unless you hold the fund in a tax-deferred retirement savings account such as a 401(k), you must report those capital gains on your tax return.

Measuring your money manager’s “tax efficiency” isn’t that hard. Mutual funds report their turnover rate in their annual report and prospectus. Look for it under the “Financial Highlights” section.

The rate is expressed as a percentage. For example, if the portfolio had sold stocks equal to the value of the entire portfolio in the past year, the fund’s turnover rate is 100 percent.

Generally, the lower a fund’s turnover rate, the better its returns. When a fund trades, it must pay trading costs, and those commissions come out of the fund’s investment return.

A group of funds Morningstar studied with annual turnover rates below 20 percent had an average annual 10-year return 1.58 percentage points higher than the average for funds with turnover rates of more than 100 percent, Morningstar said.

That doesn’t mean you should steer clear of all high-turnover funds.

Morningstar’s study found that turnover did the most damage to funds investing in large companies and those that invest in growth and value companies. On the other hand, rapid-fire trading coincided with better returns for funds investing in small-capitalization and growth stocks because those shares tend to be more volatile.