All mutual funds buy and sell securities. Securities in an actively managed portfolio may be sold because they are not performing as expected, they no longer fit within the portfolio (e.g., a value stock has appreciated so much it is now considered a growth stock), to free up cash to take advantage of another opportunity or to satisfy shareholder redemptions.
Existing positions may be added to as new monies flow into the fund or because the characteristics of the security are now more appealing. In the case of passively managed funds, securities are bought and sold due to inflows or outflows of cash (e.g., investors adding money, dividend income needs to be invested, etc.) or because the index the fund is replicating has changed with the addition or subtraction of specific securities.
The turnover ratio measures fund yearly trading activity. It is calculated by taking the lesser of purchases or sales, dividing that number by average monthly net assets. Securities with a maturity of less than a year are not considered.
As an example, the XYZ fund purchased $100 million of stocks and $20 million of 6-month Treasury bills. The fund also sold $120 million of equities and long-term bonds during the year. The average amount of assets on a monthly basis for the XYZ fund over the past year was $500 million. Thus, the turnover ratio of the XYZ fund was 20% ($100 million divided by $500 million).
One way to view the turnover ratio is it roughly represents the percentage of the fund’s holdings that have changed over the past year. Using the example in the paragraph above, this means the XYZ fund, on average, changes its portfolio completely once every five years (100% divided by 20%).
A turnover ratio is a “rough” number because many funds will hold onto a large bulk of their holdings for a number of years. Activity may be focused on a small or moderate percentage of the portfolio. In such instances, it would be misleading to say the fund changed all of its positions once every X years; a more correct explanation is a certain portion is traded (frequently), while most others are held for a number of years. On the other hand, there may be instances when much of a fund’s holdings are sold over the course of a couple of years. In such cases, the formal definition of turnover ratio would be accurate.
Managers who keep turnover low often practice low-risk strategies. A low-turnover fund will often greatly improve your clients’ odds of good long-term performance.
Three Ways to Compute Turnover
There are three commonly used ways to calculate turnover: simple average, median, and asset-weighted. The simple average turnover rate is what the vast majority of sources use when reporting turnover; such figures are also shown in the financial highlights of the fund’s annual report. This method treats each fund equally when computing a category or peer group average, such as “large cap growth funds.”
The median turnover rate is a number at which half of all funds in the category or classification have a turnover rate higher than the median and the other half has a rate lower than the median. According to ICI, the median turnover rate is “a more accurate depiction of the turnover behavior of stock funds.”
The asset weighted turnover rate identifies funds investors are most heavily invested. Such a calculation gives greater weight to funds managing more money. According to the industry trade group, the Investment Company Institute (ICI), the asset-weighted method reflects what “shareholders actually experience in their funds.” ICI figures indicate the asset-weighted turnover rate for all stock funds was 50% in 2004, and two-thirds of all stock fund assets were in funds whose turnover rates were under 50%.
The Institute of Business and Finance (IBF) believes the correct way to present turnover rates is by using the simple average method. Such computations are consistent with how other fund statistics are presented (e.g., tax efficiency of a category, average annual returns of a sector group, etc.). ICI’s favored method (i.e., asset weighted) downplays the numbers and is not consistent with other ICI calculations, advisory services, or SEC reporting requirements.
Turnover for the average equity fund is about 90–100%, but you might see portfolios with ratios above 500%. At the other extreme, index funds might have minuscule turnovers of just 5–10%. Turnover rates for stock funds generally fall into the following broad ranges:
Low turnover Up to 30%
Average turnover 40% to 100%
High turnover > 120%
Portfolio turnover for the past years is found in the financial highlights table. As with performance and expense numbers, compare turnover for similar types of funds and look at an average over several years. Turnover varies by type of fund and the investment philosophy of the manager. Some managers seek quick profits and tend to buy and sell aggressively. Others follow a long-term buy-and-hold strategy.
Funds relying on options, futures, and short-selling strategies can be expected to have higher turnovers and transaction costs. Other things being equal, high turnover is a drawback. A high number can mean excessive trading expenses. The table below shows the average turnover ratios for a number of equity and fixed-income categories.
Mutual Fund Turnover Ratios
Large Cap Blend
Foreign Large Growth
Large Cap Growth
Foreign Large Value
Large Cap Value
Foreign Sm./Mid Growth
Mid Cap Blend
Foreign Sm./Mid Value
Mid Cap Growth
Emerging Markets Stock
Mid Cap Value
Small Cap Blend
Small Cap Growth
Small Cap Value
Emerging Markets Debt
Foreign Large Blend