A mutual fund's turnover ratio is the rate at which its holdings “turn over," which is an indication of the fund's buying and selling activity. For example, a turnover ratio of 300 percent means the fund manager has replaced all securities in a fund's portfolio three times within a year. According to CBS MoneyWatch, a turnover ratio of between 80 percent and 100 percent is the norm.
While it is important to estimate the likely financial reward of a fund manager's investment strategy, it is equally important to understand the amount of this reward you will be allowed to keep. The more aggressive a fund's investment objectives, the more likely its turnover ratio will be high. High turnover drives up the cost of your fund shares because buying and selling expenses, such as commissions, are deducted from your fund's performance on a daily basis.
If a fund sells securities, the sale results in a taxable event for the investor. As a mutual fund owner, you are taxed on the profits earned when mutual fund shares are sold. You are also taxed on the net profits generated by the buying and selling of fund assets by the fund manager. Taxes are incurred on these profits even if the gains are reinvested in more fund shares. If the sale is classified as a short-term sale, tax is paid at your marginal federal income tax rate. High buying and selling activity can lead to a capital gains tax liability that is higher than that of an unmanaged index fund, which trades shares less frequently. As a result, an unmanaged index fund may generate less taxable income.
To help with taxes, you might consider holding high-turnover funds in a tax-deferred account such as a mutual fund IRA or 401(k). Consider holding a lower-turnover fund – less than 100 percent turnover – in a fully taxable account. For example, index funds often follow a buy-and-hold strategy. As a result, some index funds have a turnover ratio that’s below 10 percent. Also, consider the funds' management and operating fees.
Fund asset turnover and fund expenses are linked. As a turnover ratio declines, the expense ratio will probably decline because of fewer buying and selling expenses. As a result, a fund that buys and holds assets for an extended period will likely incur lower fees than one that buys and sells stocks on a daily basis. Therefore, you might also screen mutual funds based on their expense ratios, rather than just their turnover ratios. Note that while 12b-1 fees, management fees and operating expenses are included in the expense ratio, purchase and redemption fees are not.
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