How to Examine a Mutual Fund's Portfolio Turnover

How to Examine a Mutual Fund's Portfolio Turnover

A mutual fund's portfolio turnover is the percentage of stocks, bonds & other securities that are bought and sold during the course of one year. For example, consider a hypothetical ABC Fixed Income fund reports a portfolio turnover of 40% for the year 2010. Assuming the fund held 100 stocks at the beginning & ending of the year, it will have sold 40 stocks during the course of the year and replaced them with 40 newer stocks. In other words, at December 31st, 2010, the fund still held 100 stocks but replaced 40 old stocks with 40 newer ones. If the fund's turnover rate was 100%, then all 100 stocks would have been sold & replaced with 100 newer stocks.

Portfolio turnover is a great way to measure the investment quality of a mutual fund because a higher turnover means increased costs of trading, which is paid for by investors' money and not the fund manager's salary. Also a mutual fund with a higher portfolio turnover is geared more towards short term trading which involves more risk. For instance, a fund with a 20% turnover rate will deplete itself with 100% new stocks in 5 years whereas a fund with a 100% turnover rate will replace all stocks within 1 year. This trend indicates a fund manager's ability in picking value-oriented long term stocks versus short term trading opportunities.

Low or High Turnover?

So how can you tell if your mutual fund should have a lower or higher portfolio turnover? Here are some guidelines:

* Small cap, international & growth oriented mutual funds tend to have higher turnover because of the nature of their investment holdings. The transactions going through these funds are heavy in nature as managers try to seek the best growing opportunities & competitive advantages.

* Index funds have lower portfolio turnover because they aim to benchmark the returns of a bigger index such as Standard & Poor's 500 Index (S&P 500). The holdings of such large indexes such as the S&P 500 index do not change frequently.

* Fixed income bond funds have higher portfolio turnovers because they trade frequently to seek the highest bond yields.

Effect of Trading Costs

* Let's say a large mutual fund with a capitalization in excess of $10 billion decides to sell all its holdings in Coke worth $500 million. Such a large transaction will require weeks to complete and the first set of shares will sell for more than the 2nd set of shares, thus putting downward pressure on Coke's stock price. Since the fund receives a lower price for its 2nd set of liquidated shares, this is an indirect loss to the mutual fund. We'll say it amounted to 0.5% loss of value.

* Upon selling Coke, the fund will most likely buy another set of shares, let's say Apple. Since purchasing $500 million worth of stock is a huge transaction, the fund will likely have to bid a higher price for Apple's stock just to be able to fill its position. This puts upward pressure on Apple's price and forces more liquid cash out of the mutual fund. We will assume another 0.5% loss of value.

* When we combine the loss of value from the above 2 transactions, they represent 1% total. Since most mutual funds return an average 9% a year, this 1% eats away in to the returns without most investors' knowledge. Also be aware that trading costs do NOT form part of a fund's expense ratio.

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