Investors may opt for a buy and hold strategy, or may be active in trading based on the opportunities the markets provide. While this is simple for stock investors to decide on the strategy as they can trade themselves, mutual fund investors need to rely on the fund managers. However, mutual fund investors need not lose heart, as a look at the portfolio turnover would indicate part of the strategy the fund manager is following for the respective fund.

Investors looking for active trading would prefer funds with high portfolio turnover or turnover ratio. Obviously then, a buy-and-hold strategy investor would look for funds that offer a lower turnover.

This is because the portfolio turnover is the measure of how often a fund buys and sells assets. It is generally calculated after considering the total amount of securities sold or bought (whichever is lower) over a fixed period and then divided by total net asset value. Usually, the turnover is calculated for a 12-month period.

The turnover ratio is therefore simply the ratio of the rate of turnover. A turnover ratio of 500% implies the fund manager has replaced all holdings in a portfolio five times in a year. Again, trading half of the holdings ten times in a year would also give us a turnover ratio of 500%.

Good or Bad?

Most importantly, high or low turnover ratio is never an indicator of the fund’s performance. High turnover ratio does not necessarily mean more profits or it does not assure high returns going forward. Similarly, low turnover ratio is not a litmus test for guessing a fund’s performance.

Nonetheless, it serves the purpose of understanding the trading strategy, which is crucial for investors. Morningstar notes that turnover figure between 20% and 30% reflects a buy-and-hold strategy. Turnover above 100% on the other hand reflect high buying and selling activity.

It also helps the cost-conscious fund investors, as every transaction would carry charges. Buying or selling securities carry various expenses, including the taxes made on capital gains. Thus, the good and bad aspect also involves the related costs that the fund will have to bear.

The Cost Factor

Every transaction will come at a cost, which eventually is passed on to the investors. So very high trading activity, or high turnover ratio, may be bad if the high expense ratio dampens the total return.

Investopedia notes: “Unless the superior asset selection renders benefits that offset the added transaction costs they cause, a less active trading posture may generate higher fund returns”. Then again, low turnover ratio funds that show minimal gains are also bad options as the fund may be in dire need of a restructuring in its holdings.

However, transactional brokerage fee charges are not included in operating expense ratio. These are paid from the fund’s assets. High turnover expenses may not be good. However if the total return is significantly high to beat any adverse effect of the transactional cost, then the strategy of active trading is not a problem. Consistent above-average returns can justify high turnover ratio.

Acceptable Turnover Ratio

For certain categories of funds, it is acceptable that they will have high turnover ratio. Money market mutual funds invest in short-term interest bearing securities, for which it carries a high turnover ratio. Again, growth mutual funds will carry high turnover ratio as the investment objective is to constantly be on the lookout for sectors poised to be the forthcoming leaders.

On the other hand, value mutual funds are said to maintain low turnover ratios as they look to invest in undervalued securities and wait for them to reach the targeted value. Index funds too will carry low turnover ratios. This is because buying and selling is only needed when there is a change in the underlying index.

Highest & Lowest Turnover Ratio

The following charts list 5 funds having the relatively the highest turnover rate and 5 funds having the lowest (at least turnover rate of 0.5):

The fund's portfolio turnover rate are mentioned as of the average value of its portfolio.

Highest Turnover Ratio:

 
Lowest Turnover Ratio:

The charts reveal that high or low turnover ratio does not assure the fund performance. For instance, Forward Tactical Enhanced A (FTEAX - MF report), carrying a Zacks Mutual Fund Rank #3 (Hold), has the highest turnover ratio but its one-year return is a negative 6.7%. However, Fairholme Fund (FAIRX - MF report), holding a Zacks Mutual Fund Rank #5 (Strong Sell), carries turnover ratio of just 2% and has returned a negative 3.3%. On the other hand, Invesco Income Allocation A (ALAAX - MF report), carrying a Zacks Mutual Fund Rank #1 (Strong Buy), has turnover ratio of 4% but has returned 7.3%.

Again, Rydex Dow 2x Strategy A (RYLDX - MF report) and Rydex Electronics A (RYELX - MF report) have high turnovers of 3338% and 1436%, respectively. These Guggenheim funds have returned 21.7% and 20.5%. Separately, Zacks Mutual Fund Rank #2 (Buy) funds Eaton Vance Tax-Managed Equity Asset Allocation A (EAEAX - MF report) and Homestead Value (HOVLX - MF report) carry turnovers as low as 1% and 2%. They have returned 9.9% and 14.5%, respectively.