The Hidden Ratio The Experts Use To Keep Mutual Fund Fees Low

By Andrea Travillian
April 01, 2013
Every year in January, I do a big portfolio review. I rebalance my portfolio and make sure that I still like my current mutual funds and ETFs. And I get to know the turnover ratio for each mutual fund.
 
Why do I look at this ratio? It tells you how frequently a fund manager is trading. 
 
That's a crucial piece of information because every trade costs you money. These trades can drive your hidden expenses. In short, more fees mean less return for you.
 
Let's look at how the mutual fund turnover ratio is calculated and how this ratio will help save you money.
 
Turnover Ratio Calculation
 
The turnover ratio is a percentage of the assets that change each year within the fund. It is determined by taking either the total of the securities purchased or the amount of securities that are sold (whichever is a smaller amount) and dividing that by the assets. 
 
Looking at it another way, a ratio of 50% says that, on average, the fund is holding a stock for two years. If the turnover ratio is 100%, then in theory, the portfolio is completely new every year. The higher the number, the more active trading the fund is doing.
 
Here's why a high turnover ratio costs money.
 
Fees
 
Every time a manager makes a trade, your costs go up because of higher commissions. This cost is not included in your annual operating expense, so it increases your costs overall. Frequent transactions mean more money out of your pocket.
 
Tax Implications
 
Every time a mutual fund sells a holding, it creates either a profit or a loss. All profits from the sale of the asset are then passed along to you to pay taxes. If your mutual fund is in a tax-protected account, such as an IRA, you don’t need to worry about this extra investment cost.
 
On the other hand, if you own the mutual fund in a taxable account, you will pay taxes on the profit at the end of the year -- even if you have not sold any of your shares in the mutual fund
 
Moving The Market
 
If the mutual fund is selling a large enough position, it can drive the asset price lower. This means the fund gets less money for the shares that are sold. Likewise if the fund buys a large enough position, the price may increase, thus causing the fund to pay more for the asset.
 
Problems With The Turnover Ratio
 
There are two situations in which the turnover ratio may be inaccurate:
 
  • If the fund increased its assets and the rate of trading has not changed, the ratio will decrease because the assets are higher. 
  • Likewise, if the fund decreases in assets, the ratio will move higher because there are fewer assets in the fund.
The Investing Answer: The best way to keep your costs down, other than a low expense ratio, is to invest in a fund that has low turnover. But what is a good ratio to target? Your typical buy-and-hold strategy is going to have a ratio of about 25%. A domestic index fund is typically going to be under 5%.
 
Personally, most of my funds have turnover ratios of about 20% for actively managed and about 3% for index funds. I hate fees and know that they can kill your performance quickly, so I like to keep funds that are doing very little trading. 


Andrea Travillian made her first stock purchase in sixth grade. Deciding to pursue a career in the field, she received a BBA and MBA in finance. Today, she covers personal finance topics on her site, Take a Smart StepIssues include investing for beginners, debt and money emotions.

This article originally ran at TakeASmartStep.com:
Mutual Fund Turnover Ratio: What You Need to Know to Pick a Fund