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Why Does Fund Turnover Matter?

Mutual fund managers deliver returns to investors by building portfolios of securities that they purchase primarily through securities exchanges. Each time an equity manager decides to buy a stock, they place the trade through one of a number of brokers. Mutual fund managers strive to execute these trades in the best possible way, but they cannot avoid certain costs. The industry referes to these costs as Transaction Costs.

The Securities and Exchange Commission has identified four major types of transactions costs:

  • Commissions:Charges that a broker collects to act as agent for a customer in the process of executing and clearing a trade.
  • Spread Costs: Costs incurred when a fund buys a security from a dealer at the "ask" price (slightly above market value) or sells a security to a dealer at the "bid" price (slightly below market value). The difference between the bid price and the ask price is known as the spread.
  • Market Impact Costs: Costs incurred when a price of a security changes as a result of the effort to purchase or sell the security.
  • Opportunity Costs: Costs related to missed or incomplete trades.

Of the four types of transaction costs, only commission are directly measured and disclosed by mutual funds. Because most of these transaction costs are difficult to measure directly, investors have used fund turnover as a way to proxy for these costs when making investment decisions. Although it is indirect, the industry has embraced this metric as a way for investors to evaluate a fund's transaction costs:

  • SEC: “The requirement to disclose portfolio turnover rate is premised on the observation that a fund's transaction costs tend to be highly correlated with its turnover rate, other factors held equal. Thus, by comparing turnover rates, investors can obtain an indication of how transaction costs are likely to vary among different funds.”
  • Investment Company Institute (ICI): “While portfolio turnover rate is not a perfect proxy for fund trading costs, it is generally viewed as being highly correlated with transaction costs. In addition, it can be easily calculated by funds, and is easily understood by investors and readily comparable among funds. We believe that these advantages outweigh any imprecision of a portfolio turnover rate's correlation to trading costs.”
  • Fidelity: “The turnover rate is a useful number for investors. While it is limited, it is also simple, objective, and relatively well understood. Turnover rates can be augmented by associating them with commissions paid as a percent of assets. Those two figures are probably the best available proxies for transaction costs at this time.”
  • Vanguard: “We believe that increasing the visibility of a fund's turnover rate is crucial. It is easily quantifiable, generally understood by investors, and most important it is a critical factor in determining transaction costs. Turnover rate is a good indicator of total transaction costs not only for stock funds, but also for balanced and bond funds.”xiii

The SEC and the investment management industry have provided investors with the turnover ratio as a way to help understand the impact of transaction costs on fund performance. While it is an imperfect metric, it is the best tool investors currently have for estimating the impact of transaction costs on their investment alternatives.

BrightScope is pleased to add a couple of small enhancements to our turnover metrics that we believe will assist investors understand a fund transactions costs.

  1. Trended Turnover: A fund's turnover rate is not constant. In any given year the fund may trade more or less than it has in the past. BrightScope's turnover graphs show multiple years of trended turnover calculations so investors can see not only the most recently reported turnover statistic, but also how the fund's turnover has changed over time.
  2. Underlying Data: The actual turnover rate is a calculation that takes the lesser of a funds purchases and sales and divides that number by the average net assets in the fund. The act of taking the lesser of the purchases and sales is a way to net out flow-driven trades from the turnover calculation. However, we believe investors should considert total purchases and sales, not just the absolute fund turnover. This will give an investor's a more complete picture of the trades that were performed either for investment purposes or flow-driven purposes.

Here is how that information looks:

 

BrightScope Turnover Example

In summary, investors should not overlook fund turnover as an indicator of a fund's transaction costs, and should seek to invest in funds that have low expense ratios and turnover rates.

Ryan Alfred
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Comment   |  2 years, 6 months ago from San Diego, CA