Portfolio Turnover

Portfolio turnover is a measure of how frequently assets within a fund are bought and sold by the managers. Portfolio turnover is calculated by taking either the total amount of new securities purchased or the amount of securities sold (whichever is less) over a particular period, divided by the total net asset value (NAV) of the fund. The measurement is usually reported for a 12-month time period.

The portfolio turnover measurement should be considered by an investor before deciding to purchase a given mutual fund or similar financial instrument. After all, a firm with a high turnover rate will incur more transaction costs than a fund with a lower rate. 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.

In addition, cost conscious fund investors should take note that the transactional brokerage fee costs are not included in the calculation of a fund's operating expense ratio and thus represent what can be, in high-turnover portfolios, a significant additional expense that reduces investment return.

The debate continues between advocates of unmanaged funds such as index funds and managed funds. A 2015 Morningstar study revealed that index funds outperformed large-company growth funds about 68% of the time in the 10-year period ending Dec. 31, 2014. Unmanaged funds traditionally have low portfolio turnover. Funds such as the $410.4 billion Vanguard 500 Index fund mirror the holdings of the S&P 500 in which components infrequently are removed. The fund turns over at an annual rate of 3.1%, helping to keep expense ratios low as the result of minimal trading and transaction fees.

While some investors avoid high-cost funds, there exists the possibility that an individual may miss out on superior returns that consistently outperform index funds. Seasoned fund managers that have consistently beat the benchmark S&P 500 include 85-year old Ab Nicholas. The fund’s turnover rate averaged in the 19.47% range in the year ending Sept. 30, 2017. Despite increased buying and selling, the fund outpaced the S&P 500 in each year from 2008 through 2015.

Portfolios that turn over at high rates generate large capital gains distributions. Investors focused on after-tax returns may be adversely affected by taxes levied against realized gains. Consider an investor that continually pays an annual tax rate of 30% on distributions made from a mutual fund earning 10% per year. The individual is foregoing investment dollars that could be retained from participation in low transactional funds with a low turnover rate. An identical 10% annual return to an investor in an unmanaged fund results largely from unrealized appreciation.

If a portfolio begins one year at $10,000 and ends the year at $12,000, add the two together and divide by two to get $11,000. Next, assume the amount of purchases totaled $1,000 and the amount sold was $500. Finally, divide the smaller amount -- buys or sales -- by the average amount of the portfolio. For this example, the smaller amount is the sales. Therefore, divide the $500 sales amount by $11,000 to get the portfolio turnover. In this case, the portfolio turnover is 4.54%.