Higher mutual fund turnover means higher securities trading costs, which reduce investment fund performance.
Short-term mutual fund trading is a zero sum game played against other very well informed mutual fund traders and other securities market traders. On average, higher mutual fund turnover is far more likely to result in lower investment fund performance — instead of superior risk-adjusted performance.
Higher stock and bond mutual fund turnover indicates that management is very active in buying and selling. Higher mutual fund turnover indicates a shorter-term strategy to pursue supposedly superior returns. The investment fund manager hopes that his or her short-term speculative insights will allow the fund to beat others in the highly competitive securities markets.
Most often, however, the very active investment fund manager will be wrong about the supposed virtues of more frequent trading. When securities trading volume is greater, then even higher investment fund performance is required just to break-even on the associated incremental securities trading costs.
The primary impact of excess turnover is to drive up trading costs, which tend not to be visible to individual investors. Such trading costs include brokerage commissions, the bid/ask spread, and the market impact, if mutual fund trading causes the bid-ask spread to move temporarily to absorb higher trading volume.
The mutual fund turnover ratio serves as a visible proxy to measure the more hidden securities trading costs of actively managed mutual funds.
Such securities trading costs are not detailed in the information that is easily available to mutual fund investors. Trading costs are not paid out of the management expense ratio of the mutual fund, but instead securities trading costs directly reduce the reported investment fund performance and net asset value of the fund’s securities portfolio.
When compared to funds of a similar style, a fund’s turnover ratio gives a good indication of fund activism. Investment research studies have demonstrated that lower turnover is better.
Certain fund management styles will be characterized by low turnover, such as noload mutual funds that track passive indexes. Certain fund management styles, such as aggressive growth equity or stock mutual funds, will have far higher mutual fund turnover. Unfortunately, the investment research literature does not demonstrate that higher turnover leads to better performance.
In fact, the opposite is true. The great majority of actively managed funds with high turnover do not demonstrate better investment fund performance results, after the additional trading costs are taken into consideration. Furthermore, no reliable way has been shown to identify beforehand the minority of higher turnover funds that will eventually do better. You are far more likely to pick from the majority of higher turnover funds that will do worse — sometimes much worse — because of their added costs.
When you select noload mutual funds, look for funds with the lowest turnover. Very low turnover funds are much more likely to provide superior investment fund performance.
The reason is simple. Low turnover noload mutual funds avoid the additional drag of higher securities trading costs.
The automated application that you use to screen mutual funds should allow you to screen for portfolio turnover. Turnover will usually be calculated as a percentage of the fund’s average portfolio value on an annual basis. Annual percentage turnover could range from a very minor part of 100% to a number that is many times 100%.
For points of reference, Morningstar provides mutual fund turnover statistics for major types of funds. Morningstar data indicates that actively managed domestic stock mutual funds have average turnover of about 100%. Average turnover percentages are similar for international stock funds.
Taxable bond funds had average turnover around 150%. Of course, bond mutual fund turnover can vary significantly due to the average duration of the bonds within the fund. Municipal bond funds typically have much lower turnover of around 25% per year. Over time, these mutual fund turnover averages for actively managed funds may shift.
In contrast, passively managed, stock index noload mutual funds have far lower turnover and therefore far lower trading costs. The best noload stock index funds will have single digit annual percentage turnover ratios or at least very low double digit percentages.
Concerning bond market index funds, these usually are passively managed noload mutual funds holding fixed income securities. Noload bond funds will have turnover that also varies, because of the average duration of the bonds in the fund. Nevertheless, noload bond index funds should almost always have lower turnover, when compared to more actively managed bond mutual funds.
