The turnover ratio is a rather mundane statistic that tends not to attract much notice until we see an outlier, such as 293%. In reality, turnover is an important component of our proprietary mutual fund scoring metric, where it stands as proxy for trading and other market costs that aren’t included in a fund’s expense ratio.
The SEC requires that mutual fund companies calculate and report their turnover ratio as part of the fund’s Annual Report. A fund’s turnover ratio is generally obtained by finding the lesser of a fund’s purchases or sales (excluding securities with maturities less than one year) and dividing that number by its average monthly net assets.
For most equity funds, turnover is relatively straightforward. Funds with lower turnover tend to be long-term buy-and-hold strategies and should have lower trading costs, while funds with higher turnover are more active and are likely incurring greater market and trading expenses. Turnover is also useful to us in evaluating a manager’s adherence to their stated investment philosophy: managers that claim to invest for a full market cycle should have relatively low turnover (generally below 40%), while momentum-focused managers will typically have higher numbers. That said, turnover as a measure of a fund’s investment philosophy can be somewhat misleading since the stated number includes all trading activity, including portfolio maintenance (adding to or trimming existing positions to address changing conviction levels or risk).
Turnover becomes more complex as we move to the fixed income side where we more often see funds with turnover exceeding 100%. While equity funds tend to focus on security selection and asset allocation, bond funds have additional levers, including yield curve positioning, duration, and currency exposure, that may be used to generate excess returns. Given the high level of liquidity in Treasuries, many bond managers buy and sell Treasuries to manage their fund’s overall duration. Managers who invest in international bonds may use currency futures of varying maturities to neutralize currency risk or to increase exposure to a desired currency, while managers of investment grade or high-yield debt may use credit default swaps to achieve desired exposure while managing for market liquidity and risk. Another component of bond fund turnover may be related to a practice known as “mortgage rolls” wherein the fund sells current securities and through a counterparty arranges the forward purchase of similar, but not identical securities, at a potentially lower cost. For one fund we recently studied, mortgage rolls accounted for more than one-third of the fund’s 293% annual turnover.
While portfolio turnover upwards of 200% or even 300% may be surprising, it is important to understand what lies behind the number. All trading activity adds cost and complexity; the real question is, is it adding value for investors or just creating a drag on returns?