Portfolio Turnover Ratio

The portfolio turnover ratio, often just called the turnover ratio, measures how much of a fund's portfolio has been replaced during a year. A turnover of 20% means that, roughly speaking, a fifth of the holdings were sold and replaced; 100% means the equivalent of the whole portfolio was traded. It is a quick gauge of how actively a manager trades and of the hidden trading costs and tax bills that trading can create.

In the United States every mutual fund and exchange-traded fund (ETF) must report its turnover rate for the last fiscal year in its prospectus and in the financial highlights of its shareholder reports, using a method set by the Securities and Exchange Commission (SEC) in Form N-1A. The figure is also a standard line on a fund fact sheet.

Imagine a library that owns 1,000 books. If, over a year, it gets rid of 200 old books and buys 200 new ones, it has "turned over" 20% of its collection. A library that swaps out all 1,000 has turned over 100%.

A fund works the same way. A manager who buys good companies and holds them for years has low turnover. One who trades often, chasing short-term moves, has high turnover. Each swap has a cost, rather like a delivery charge on every book, and those costs come out of the investors' money.

Under the SEC's Form N-1A instructions, turnover is calculated as:

• $\text{Purchases}$ is the total value of portfolio securities the fund bought during the fiscal year.
• $\text{Sales}$ is the total value of portfolio securities it sold in the same year.
• $\min(\cdot)$ means take whichever of the two is smaller.
• $\text{Average value of portfolio securities}$ is the monthly average of the value of the securities the fund held over the year.

Securities that had a maturity of one year or less when acquired, such as Treasury bills and other cash-like holdings, are left out of both the top and the bottom of the fraction.

Example: a fund buys $40 million and sells $50 million of securities during the year, and its holdings averaged $200 million. The lesser figure is $40 million, so turnover is $40 \div 200 = 0.20$, or 20%. Using the smaller figure stops a fund from showing high turnover just because investors put money in (which forces purchases) or took money out (which forces sales). A rough rule of thumb is that the average holding period is the inverse of turnover: at 20%, about $1 \div 0.20 = 5$ years.

• Index funds that track a broad stock market index often report turnover in single digits, since they trade only when the index changes.
• Actively managed equity funds commonly fall between about 30% and 100%, depending on style; growth investing strategies often trade more than buy-and-hold value strategies.
• Bond funds, especially those managing interest rate risk actively or using mortgage "roll" trades, can report turnover well above 100%.

First, trading costs. Brokerage commissions, bid-ask spreads and market impact are paid out of fund assets but are not part of the expense ratio, so a fund with a low stated cost can still be expensive to own if it trades heavily. Commissions are disclosed separately in the statement of additional information; spreads are not disclosed at all.

Second, taxes. Selling a holding at a profit realises a capital gain. US funds must pass net realised gains to shareholders as a capital gains distribution, and gains on holdings kept a year or less are passed through as short-term capital gains, which are taxed at ordinary income rates rather than the lower long-term rates. Two funds with identical pre-tax returns can therefore leave a taxable investor with noticeably different after-tax results. High-turnover funds are therefore often better held in tax-advantaged accounts such as an IRA.

Turnover says how much a manager trades, not whether the trading is any good. A thoughtful active manager may add alpha with high turnover, while a low-turnover fund can still underperform. The ratio can also be distorted by large inflows or outflows, mergers, or strategy changes during the year, and ETFs that meet redemptions by delivering securities "in kind" can show lower turnover than their underlying trading activity. It is best read alongside the expense ratio, total return after fees and the fund's stated investment objective.

• Investor.gov (SEC): Turnover Ratio