Tag Archives: mutual fund

Fund Turnover Ratio Can Cost You Money

Cut-costs-with-low-turnoverSomething 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 ┬áleast 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?

How Are Target Date Funds Put Together and Can We Do Better?

Most target date funds automatically adjust their asset allocation (AA) from aggressive investments, usually in other mutual funds, to more conservative as they approach their target date.

That is not to say they will hold 100% short term bonds or cash after they reach their target date. Vanguard’s Target 2010 fund has holdings of

41.9% Total Bond Market II Index Fund
29.2% Total Stock Market Index Fund
14.1% Inflation-Protected Securities Fund
12.7% Total International Stock Index Fund
2.1% Prime Money Market Fund

which is essentially the same as as a 3-fund portfolio made up of Total Stock Market ( TSM)/Total International Stock Market (TISM)/Total Bond Market (TBM), with asset allocation of 29.2%/12.7%/58.1% .

Target date funds typically do not reduce their stock allocation by the same amount each year. They try to follow a “glide path” of decreasing risk by adjusting their fund allocations as they near their target date. The plot below shows the AA glide path used by all Vanguard target date funds.

vanguard target date glidepath plot

I have three concerns with target date funds.

One is that they typically carry a higher percentage of stocks to bonds than they probably should. This can be too much risk for a typical investor. Many target date funds were sold during late 2008 and early 2009 because investors panicked after experiencing large losses. Vanguard Target 2025, which is only 12 years away from the target AA has an asset allocation of 49.3/20.7/30 TSM/TISM/TBM. This is nowhere near Jack Bogle’s “age in bonds” recommended allocation. I am sure that much of the over-weighting in stocks is so that they can advertise higher returns for their funds. All target date funds seem to do this.

My second concern is that their expense ratio (ER) is typically higher than the combined ERs of a comparable 3-fund portfolio. The Vanguard 2025 target fund has an ER of 0.17%. The weighted average ERs of a similar Vanguard 3-fund portfolio, using admiral shares, is 0.09%. And most target date funds have higher expenses than Vanguard.

My third concern is that they may contain actively managed funds. Looking at another example, some of my old 401(k) money is in a Schwab brokerage account. My company recently rolled a portion of the 401(k) that was held in a large pool that the company controlled for all employees into appropriate Schwab target date funds for each employee. I noted that the Schwab 2025 fund, which was chosen for me, had an ER of 0.72%. It holds some low-cost index funds, but also holds some actively traded funds. It has 21 funds in all, which I won’t bother to list.

For simplicity, I decided to split the Schwab 2025 target fund into just two funds, TSM and TBM with an AA of 50/50. The ER for the TSM and TBM using Schwab ETFs, which are available in the old 401(k), is

  • 0.04% for SCHB
  • 0.05% for SCHZ

or 0.045% for the combined fund ER. I know this does not exactly compare to how I looked at Vanguard using 3 funds, but my goal was to get rid of the actively managed funds and their expenses. Since my AA of 50/50 is already in the flat part of my glide path, I will not have to change the AA as I get older. It is now a target date fund using the AA that I want with an ER that is 93.75% less expensive than the Schwab target date fund. (And don’t forget that expenses compound every year.)

I will probably have to rebalance the funds over time to maintain the 50/50 AA, but that is a post for another time.

Does the NAV Matter When Comparing Two Mutual Funds?

Q-and-A

A person in an investing forum asked which fund to invest in within his 401(k). The choice was between a large-cap growth fund with an expense ratio (ER) of 0.79% or the Vanguard Institutional Index fund with an ER of 0.04%.

Most respondents answered that he should buy the Vanguard fund which has broader diversification and much lower cost. The person responded that he knew the Vanguard fund had the lowest ER, but that it was too expensive at $155 and felt he should buy something that cost less.

The $155 cost is the fund’s current net asset value (NAV). Should we care what value a NAV is when comparing funds?

The NAV is calculated for each fund at the end of each trading day. It is derived by dividing the total value of all the cash and securities in a fund’s portfolio by the number of shares outstanding. The value of the NAV does not matter unless you are trying to time the market, which is a loser’s game.

Whether a fund’s NAV is $15 or $150, the things that matter are the securities held by the fund and the fees charged to own the fund. The Vanguard fund has more securities, and thus more diversification than the large-cap growth fund.

The fees consist of the ER and any purchase or sales fees. The lower the fees, the better. In this case the fees of the Vanguard fund are only 5% of the fees to own the other fund. And remember, higher recurring expenses, such as the ER, get compounded each year.

After a bit of discussion, the person who asked the question said he was shifting his stock assets as well as new purchases to the Vanguard Institutional Index fund.