Something that isn’t often discussed about mutual funds is their turnover ratio. The turnover ratio is “the percentage of a mutual fund or other investment vehicle’s holdings that have been ‘turned over’ or replaced with other holdings in a given year” —Investopedia. A 100% turnover implies that the fund’s assets are completely sold and replaced every year. A 200% turnover implies that the fund’s assets are replaced every 6 months.
In general, actively managed mutual funds have a much higher turnover ratio than passively managed index mutual funds as the active managers trade stocks in an effort to beat their respective index. From Vanguard,
Turnover, or the buying and selling of securities within a fund, results in transaction costs such as commissions, bid-ask spreads, and opportunity cost. These costs, which are incurred by every fund, are not spelled out for investors but do detract from net returns. For example, a mutual fund with abnormally high turnover would be likely to incur large trading costs. All else equal, the impact of these costs would reduce total returns realized by the investors in the fund.
And from Investopedia, “A fund’s trading activity, the buying and selling of portfolio securities, is not included in the calculation of the expense ratio.” So we need to look elsewhere for how much turnover may cost.
Stefan Sharkansky published a study in 2002 titled, “Mutual Fund Costs: Risks Without Reward,” that looked at the impact of fees in the form of expense ratios, transaction costs in the form of turnover ratios, and taxes. (Note that “bps” stands for basis points. A basis point is 1/100 of a percent.)
We find a consistent negative relationship between fund turnover and performance in every category of fund that we examined. In Larger-Cap U.S. equity funds, we observed that on average, each 100% of turnover was expected to reduce the fund’s average annual pre-tax return by 124 bps (1.24%). Similarly, each 100% of turnover was shown to reduce the expected annual return by 255 bps for Smaller-Cap U.S. funds, 154 bps for International Equity funds, 43 bps for Municipal Bond funds and 9 bps for U.S. Government Bond funds. There results are within the range of other studies that have examined the costs of institutional trading and the relationship between fund turnover and performance.
Thus, we see that turnover costs are a hidden cost that investors need to be aware of. According to Morningstar, “It’s not uncommon to see turnover rates of 300% or more, even in funds that aren’t particularly aggressive.” This would mean an annual loss of at least 3.72% for funds with a 300% turnover ratio. And that’s before taxes.
300% seems high to me, but 100% turnover is very common for actively managed funds. 1.24% in turnover costs is still a huge amount for a fund to overcome just to pull even with a comparable low-cost index fund. And that does not even take into account the 1% or more in fees that most active mutual funds charge. This would put costs for an actively managed fund with 100% annual turnover at roughly 2.2% or more. Ouch.
If these funds with high turnover are held in a taxable account, much of their turnover will be realized as short-term capital gains, especially if the turnover ratio is higher than 100%. That means you could be paying capital gains taxes at your marginal income tax rate for stock sales in the mutual fund for which you never received any income.
Note that the turnover ratio for Vanguard’s Total Stock Market mutual fund is 4%, which according to Sharkansky would reduce earnings by 5 bps. Add the fund’s expense ratio of 0.05% to get a total annual cost of 0.1%, and it is apparent that low-cost passive index funds can easily beat comparable actively managed funds. Especially if you are investing in a taxable account where the added taxes due to high turnover make it almost impossible for the active funds to beat low-cost index funds.
Do you hold actively managed funds? If so, do you know what their turnover ratio is, and how much that may be costing you?