How should I use portfolio turnover to evaluate a mutual fund?

The portfolio turnover percentage can be used to determine the extent to which a mutual fund turns over its stocks and assets during the course of a year. The turnover rate represents the percentage of the mutual fund’s holdings that changed over the past year. A mutual fund with a high turnover rate increases its costs to its investors. The cost for the turnover is taken from the asset’s funds, as opposed to the management fee. Thus, mutual fund managers may not have very much incentive to reduce unnecessary trading activity.

The portfolio turnover is determined by taking the fund’s acquisitions or dispositions, whichever number is greater, and dividing it by the average monthly assets of the fund for the year. For example, a fund with a 25% turnover rate holds stocks for four years on average. The higher the turnover rate, the greater the turnover. Higher turnover rates mean increased fund expenses, which can reduce the fund’s overall performance. Higher turnover rates can also have negative tax consequences. Funds with higher turnover rates are more likely to incur capital gains taxes, which are then distributed to investors. Investors may have to pay taxes on those capital gains.

Certain types of mutual funds generally have higher turnover rates. Growth funds and funds with more aggressive strategies have higher turnovers. More value-oriented funds tend to have lower turnover. If the fund’s performance is greater than a fund with a lower turnover, the higher rate may be justified. If the turnover rate is high, while the performance is lagging, an investor may be better off looking for alternatives.