Portfolio turnover is the ratio used to describe the rate at which securities in a fund are bought and sold over a certain amount of time. This vital piece of information can give you a good idea of the amount of activity and fees a fund may have.
So what goes into these fees, and how does the turnover rate affect the amount you end up having to pay? We are going to take an in-depth look at the impact portfolio turnover has on fund expenses.
Understanding Portfolio Turnover and Its Calculation
Simply put, portfolio turnover gives you a measure of how much activity a fund has. You can find this ratio through a simple mathematical equation.
Take whichever is smaller, all of what you bought in a year or all of what you sold, and divide it by the average monthly portfolio value. Multiply that by 100, and you have your percentage.
Why it Matters to Investors
So why is portfolio turnover an important number to consider? It gives you an idea of how much buying and selling is going on in a fund. You can see if the fund is stable or volatile or if the underlying investments get flipped often. These things might matter for specific investor strategies and goals.
A high turnover rate indicates a churning of securities, which isn’t necessarily bad as long as the investments are still profitable. That said, many mutual funds and brokerages have fees and management costs associated with more active trading.
Those fees, also called fund expenses, can end up impacting your returns in the long run.
Components of Fund Expenses
An expense ratio is a percent of your investment that goes towards the operating costs of running a fund.
This number can range from <1% up to 10% or more, and that amount gets deducted from the total value of your investment annually. Since these fees impact your returns, generally, the lower the percentage, the better.
Things That Directly Affect Fund Expenses
Picture an active, high-turnover fund with more trades, research, and people working on it. As you can imagine, it will incur more fees. And depending on the fund’s historical profit margins, the current trading climate, and your time horizon, you may want to be cautious about high fees.
There are several factors of a high turnover fund that directly affect the associated expenses. Some of these include:
- Trading costs
- Brokerage fees
- Legal fees
- Marketing
- Management
- Accountants
Indirect Impact of Portfolio Turnover on Fund Expenses
Fees and payroll aside, there are also several hidden factors that a high expense ratio gets affected by.
Sometimes trades don’t happen at market value, or the fund is forced to realize gains that can get taxed. Let’s look at a few specific instances.
Market Impact Costs
Market impact costs are when the large-scale trading associated with high turnover funds can influence the price of an asset. The resulting difference between the price of the security before the trade and when it’s actually executed is a cost that can get passed down.
Bid Ask Spreads
Bid-ask spreads are the difference between the price someone is willing to buy an asset for and the price someone is selling it for. In low liquidity situations, a large gap means it can be harder to get something at market value. In those cases, the fund may have to spend more or sell at a deal to get a trade to go through.
Taxes and Capital Gains
A high portfolio turnover rate can also increase the amount of capital gains on a fund, which then gets distributed to investors. Even if the fund doesn’t sell any shares, you may be passively paying taxes on them through baked-in costs.
Quantifying the Impact of Portfolio Turnover on Expense Ratios
The expense ratio depends on the fund’s trading activity and investment strategy. In order to find the expense ratio, the fund’s operational costs are divided by its total assets. Let’s take a look at expense ratios in funds with varying turnover and what that could mean for you.
High Turnover, High Expense Ratio:
High expense ratios and high turnover mean a fund has extensive trading activity and is likely to have higher costs. Transaction costs associated with frequent buying and selling add up quickly, can eat into your returns, and incur more taxes.
Low Turnover, High Expense Ratio:
Funds with low turnover and high expense ratios have a passive investment strategy and costly operating fees. That could be due to a few factors like international staffing or the type of investments. Although there are fewer transactions, those high expenses can erode away at returns.
High Turnover, Low Expense Ratio:
If active investing aligns with your goals and risk tolerance, funds with low expense ratios and high turnover are ideal. They indicate frequent buying and selling in a bid to outperform the market and fewer fees that will impact your returns. However, it is crucial to research the fund’s past performance and ensure the strategy has been successful.
Low Turnover, Low Expense Ratio:
Low expense ratios and low turnover rates suggest a passively managed fund and are suitable for long-term investors. They aim to replicate the market rather than outperform it, and with this buy-and-hold strategy, there are fewer fees.
Impact of Fund Expenses on Investment Returns
Expense ratios directly impact your investments’ performance, and this deduction taken from your returns each year chips away at your potential for future growth. Even seemingly minor changes in the percentage can start to add up.
Although low expense ratios aren’t the only thing you need to look for in a fund, they can play a part in significantly enhancing your long-term wealth.
Strategies for Managing Portfolio Turnover and Fund Expenses
For those of us who manage our own portfolios, trades, and expenses, there are a few things to remember if you want to hit your goals.
First, consider a long-term investment approach. This strategy can keep your risk, turnover, and fund expenses minimal. If an actively-managed fund aligns more with your risk tolerance and investment goals, then be sure to do a fair amount of research.
Another thing to keep in mind is taxes. Capital gains distributions can trigger unwanted taxes. They aim to minimize year-end capital gains distributions through optimized portfolio turnover management.
Lastly, pay attention to and track your expense ratios at the end of the fiscal year. Compare them to different funds as benchmarks and ensure the cost-benefit analysis still makes sense for your goals.
Going With a Fund Manager
If you decide to go through a fund manager for part of your investments, evaluate their investment style and past performance. There are tax-managed funds to help with capital gains and reports to help add transparency.
Regulatory Landscape and Transparency of Fund Expenses
Mutual funds are subject to strict regulatory requirements by the US Securities and Exchange Commission.
They must disclose all of their fees and expense ratios in a prospectus fee table which gives investors clear and comprehensible information for easy comparison between different funds.
It details the shareholder fees, operating expenses, an example of how much an investor would pay in fees over time (1,3,5 and 10 years), and the portfolio turnover rate. They are easy to understand, and you can usually find a downloadable version of the prospectus on the fund company’s website.
In addition, regulating authorities may review and assess fees to ensure they are reasonable and that companies are following guidelines on disclosure and calculation. They will also conduct audits for accuracy and compliance.
Evaluating Fund Performance in Light of Expenses
As we mentioned above, it’s wise for self-managed investors to track their expenses throughout the year. It paints a picture of how much you’ve spent but also helps you calculate net gains vs. gross gains.
For example, let’s say you invested $10,000, and at the end of the year, your account is worth $11,000. Your gross gains are $1,000 or 10%. Now let’s say you spent $200 throughout the year on brokerage fees, ETF expense ratios, and other various costs. You subtract $200 from your $1,000 gross gains for a net gain of $800 or 8%.
Considerations for Investors from Financial Advisors
It’s always a good idea to consider how your investment returns will get impacted by expenses and incorporate regular analysis in your strategy.
- Start by learning about all the fees associated with trading and how they are calculated.
- Compare multiple fund expense ratios and look for ones that fit your goals and are transparent.
- Consider how the expenses will impact you long-term when they start to compound.
- Always keep taxes in mind and account for capital gains distributions.
- Monitor your investment portfolio and assess expenses regularly so you can stay on track with your investment goals.
Portfolio Turnover and Fund Expenses: A Valuable Correlation
It’s clear that portfolio turnover and fund expenses go hand-in-hand. The correlation between the two can give you valuable insight into how a fund is managed. Although they are two crucial components to consider, they shouldn’t be the only factors you think about when investing in a fund. Always do your research and consult a professional when in doubt.