The turnover rate in a fund is not necessarily a bad thing, but it does increase your tax bill if the fund is selling stocks with lots of short-term gains and turnover means additional hidden costs… and that comes out of your return. If turnover does hurt a fund's return, wouldn't there be a correlation between a fund's turnover rate and its after-tax return? In many cases there is.
Turnover is an important factor in determining a fund’s true costs. For example: When a fund manager makes a trade on an exchange, that trade incurs a commission – just like your own trade would – and the fund manager receives a `confirm’ reflecting the net proceeds of the trade AFTER commissions have been taken.
That’s right: Transaction costs are NOT included in the fund’s annual expense ratio! In the book, Bogle on Mutual Funds, the Vanguard Fund chairman estimated trading costs generally average 0.6% If hypothetically a fund’s turnover is 120% - check the prospectus for your fund’s turnover – here’s what it means in calculating expenses: Trading Costs (use a low-end figure) x Turnover = Total trading costs. So, 0.6% x 2.2 = 1.32%.
Why use the 2.2 factor for a 120% turnover? Simple: You have to `establish’ a position in a security before you can turn it over; and, that’s true for each security in the portfolio. The entire portfolio is established, then 120% is `turned over’ in a year.
You should add this figure (1.32% in our example above) to the fund’s annual expense ratio to get combined annual expenses plus trading costs. According to Morningstar, the typical equity fund has annual expenses of 1.4% annually. 1.32% in trading costs plus the 1.40% annual expense ratio gives a total of 2.72% in true costs.
Are we done? Nope.
There are also `market impact costs’ to consider. What’s market impact?
When you or I sell 100 shares of a security, it doesn’t really impact the price. But, when an institutional investor buys or sells huge blocks of a security, the price can be affected. How much? According to Business Week magazine (4/3/2000), market impact costs can range between 0.15-0.25%!
You guessed it: The market impact of each trade is multiplied by turnover, too. So, using the low-end market impact cost in our hypothetical, we’ll apply the turnover factor: 0.15% x 2.2 = 0.33%. Add the 0.33% to our 2.72% and we can estimate the true costs (disclosed and hidden) of our fund.
So our hypothetical fund with a 1.4% annual expense ratio that experiences a 120% annual turnover could actually be costing the shareholder 3.03% annually, quite a bit more than the 1.40% expense ratio disclosed in the prospectus. Hmmm.
Annual Expense Ratio 1.40%
Turnover 2.2 x 0.6% 1.32%
Market Impact Costs2.2 x 0.15% 0.33%
Is that bad? It depends! Some managers may be worth an extra 3.05%. Some aren’t worth a penny. Few, if any, can consistently outperform their own index.
Think about it. For a manager to tie an index that went up 10%, for example, the manager would have had to achieve a 13.05% return! You may think that’s only 3.05% over the index, but you’d be wrong. 3.05% over 10.00% is actually outperforming the market by 30.5%! No wonder so few managers outperform and virtually none can do it consistently.
It’s like anything else: Value is relative. But, it’s too bad that most investors see only the annual expense ratio and assume it’s everything they pay. As you can see from this hypothetical yet realistic example, disclosed annual expenses can actually be less than half of the total investors really pay!
That’s not all. Go pull out your last mutual fund statement that you received. I’ll wait. Read it carefully. Do you see any of your expenses and fees enumerated in dollar terms? ANYWHERE?
No fee deductions anywhere at all? Do you suppose it’s free?
Of course not. They just adjusted the fund price – the NAV - after the deduction of all costs and expenses so your costs are `hidden’ in the price of the shares.
 During the past decade, for example, the highest-turnover quartile of funds (165% annually) provided an annual pre-tax return of just 9.8 percent, while the lowest-turnover quartile (13%) returned 11.5%, an advantage of 1.7% per year—a cumulative extra profit of nearly 30%. What is more, the high-turnover quartile of funds took nearly 30% more risk (standard deviation of 20.6% vs. 16.2 percent). John Bogle, Ex Chairman, Vanguard Fund 4/12/06. And turnover also increases taxes (short-term gains are taxed at 35%, long-term at 15%) leading to this conclusion by Lipper: Taxable investors owned approximately half of the $8.391 trillion invested in open-end mutual funds, and on average over the last 10 years gave up on an annual basis 1.6 percentage points to 2.4 percentage points in return because of taxes. Taxable equity and fixed income funds shareholders surrendered over 20% and approximately 45% of their load-adjusted returns because of taxes, respectively. Source: Taxes in the Mutual Fund Industry 2006, Lipper.
Jim Lorenzen is a Certified Financial Planner® and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG provides investment and fiduciary consulting to retirement plan sponsors, and retirement and wealth management services for individual investors. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. IFG also does not provide tax or legal advice. The reader should seek competent counsel to address those issues. Content contained herein represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a written plan. The Independent Financial You can reach Jim at 805.265.5416 or through the IFG website, www.indfin.com, the IFG Investment Blog and by subscribing to IFG Insights letters for corporate plan sponsors and individual investors. Keep up to date with IFG on Twitter: @JimLorenzen