Portfolio turnover measures how often assets in a fund are purchased and sold by managers. Portfolio turnover can be calculated by dividing the total amount of securities bought or the number sold over a period by dividing it by the total asset value. The 12 months is typically used for reporting the measurement.

Understanding Portfolio Turnover

Before an investor decides to buy a mutual fund or other financial instruments, they should consider the portfolio turnover measurement. This is because a fund that has a high turnover rate will have higher transaction costs than one with a lower rate. A less active trading position may result in higher fund returns, even if the superior asset selection does not provide benefits that offset the increased transaction costs.

Cost-conscious fund investors should also be aware that transactional brokerage fees are not included in calculating a fund's operating expense ratio. They can, therefore, represent what could be, in high turnover portfolios, an additional expense that reduces investment returns.

Managed Funds vs. Unmanaged Funds

The relative merits of managed and unmanaged funds, such as index funds, remain hotly contested. Research that S&P Dow Jones Indices regularly publish examines the performance of actively managed funds in relation to the S&P 500 index. It asserts that 75% of large-cap active funds had underperformed the S&P 500 during the previous five years before December 31, 2020. A different analysis conducted by Morningstar in 2015 indicated that index funds had beaten big business growth funds by 68% overall for the ten years ending on December 31, 2014, compared to the whole time span.

Portfolio turnover is typically low in unmanaged funds. Vanguard 500 Index funds mirror the S&P 500's holdings, which are rarely removed. This fund had a portfolio turnover rate of 4% in 2020 and 2019, with minimal transaction and trading fees, which helped keep expense ratios low.

Some investors avoid high-cost funds. Investors who do this may miss out on higher returns. There are many active funds. Not all fund houses are alike. A few fund managers and fund houses are habitually beating their benchmarks, even after accounting for fees. Many successful active fund managers keep their costs low by buying and holding and making very few changes to their portfolios. There have been some cases when aggressive managers made frequent chopping or changing payoffs.

Turnover and Taxes

Portfolios that have high turnover rates can generate large capital gains distributions. Taxes on realized gains may adversely affect investors focused on after-tax returns. Imagine an investor who pays a 30% annual tax rate on distributions from a mutual fund that earns 10% annually. This individual is sacrificing investment dollars that could have been retained by participating in low-transactional funds with low turnover rates. Investors in unmanaged funds that receive a similar 10% annual return see this largely due to unrealized appreciation.

Interpreting Portfolio Turnover Ratio

A portfolio turnover ratio of 5% would indicate that 5% has changed in portfolio holdings over one year. A ratio greater than 100% indicates that all securities in the fund were sold or replaced by other holdings within a year. It is crucial to determine the portfolio turnover ratio before buying a mutual fund or similar financial instrument. This affects the fund's investment return. A low turnover ratio is preferred to a high one. Trades (buying or selling securities) have transaction costs.

It is not a bad thing to have a high portfolio turnover rate. A high turnover ratio may be justified if the fund manager can generate higher returns (on risk-adjusted terms) than an identical-style fund with a lower turnover ratio. Investors should consider alternative funds if the ratio is too high and the fund's benchmark performance is not achieved on a risk-adjusted basis.

PTR and Investment Strategies

The portfolio turnover ratio measures how well a fund manager manages their fund. A portfolio turnover ratio of 30% or less is generally considered low. The fund manager follows a buy-and-hold investment strategy if the turnover ratio is low. Passively managed funds are those with low turnover.

On the other hand, funds with high turnover rates indicate that funds are actively managed. This means they do a lot of selling and buying securities. It is a fast-paced investment strategy. Actively managed funds are those with high turnover. It is also useful to monitor the trend of the ratio. This is used to assess if the fund manager has changed his investment strategy. In three years, a portfolio turnover ratio of 20% to 80% indicates that the fund manager has drastically altered their investment strategies.