Profit margin and investment turnover both provide insight into the performance of investment portfolios, including mutual funds, although each takes a slightly different approach. These metrics can be used to track the performance of personal portfolios over time or to compare different fund options in the marketplace before trusting your money to fund managers. Savvy investors use both metrics in tandem to learn as much as possible about a portfolio's performance.
Profit represents the amount of money left over from an investment's return less the original cost of the investment. Profit margin presents absolute profit numbers as a percentage of an investment's total return. Analyzing a margin rather than pure profit allows you to more clearly compare the performance of one portfolio or fund against another, since the relative sizes of different funds can greatly skew their actual profit numbers. Consider a $1,000 investment that earns back $1,200 compared to a $300 investment that earns back $400, as an example. While the $1,000 investment earned a greater amount, the $200 gain represents a 20 percent margin, while the $300 investment's $100 gain represents a 33.3 percent margin, revealing that the investment with the smaller return actually performed better. Use the following formula to calculate profit margin: Profit Margin = (Total Income - Cost of Investments) / Cost of Investments
Interpreting Profit Margin
For investments, profit margin can directly reveal how well a portfolio generates trading profits, interest income and dividend income from its holdings. Higher profit margins come from higher performing investments, while lower margins come from weaker performance. However, raw performance is not an inherently attractive concept. Low-margin portfolios may be weighted with safer holdings, such as Treasury bills and bonds from well-established companies, which present their own distinct advantages. Choosing between high-risk, high-margin funds and low-risk, low-margin funds depends on your personal tolerance for risk and your goals for investment income.
Investment turnover reveals how often a portfolio turns over its "stock" of individual investments. Investment turnover works exactly like inventory turnover for retailers or wholesalers if you think of investments as the "products" that mutual funds sell to earn income. Like profit margin, investment turnover is presented as a ratio, showing the percentage of total assets that have been sold and replaced in a given year. Use the following formula to calculate an investment turnover ratio: Investment Turnover Ratio = Total Sales / Total Assets
Interpreting Investment Turnover
Investment turnover sheds light into how actively a given portfolio is managed. A higher turnover rate reveals that fund managers buy and sell assets more frequently, which could indicate a higher-volume, lower-margin trading strategy. A lower turnover rate reveals that fund managers hold assets for longer periods of time, which can result in higher profit gains at the expense of lower trading volume. In general, longer-term investment positions tend to carry higher risk and greater potential reward than short-term holdings. Neither strategy is inherently better than the other. The ideal strategy depends on your personal risk tolerance, time horizon and investment goals.
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