High turnover could be a red flag.
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By Katie Rushkewicz Reichart, CFA | 08-18-09 | 06:00 AM | Email Article

Investors interested in mutual funds have a lot of data at their fingertips, whether from Morningstar.com, fund company Web sites, or shareholder reports. Some investors are overwhelmed by the amount of information and just stick to the basics, like a fund's return or star rating, when they're evaluating whether a fund is worthwhile. However, there are plenty of other data points that can be quite useful when choosing mutual funds. Below we'll look at turnover ratio, which can shed some light on a manager's investment style and a fund's tax efficiency, and help you decide if a fund's a good fit for you.

Katie Rushkewicz Reichart, CFA, is a senior fund analyst on the active funds research team for Morningstar.

What Is Turnover?
On Morningstar.com, you'll find a fund's turnover ratio at the top right-hand side of the Quote page or under the Top 25 Holdings tab in the Portfolio section. Theoretically, a fund's turnover ratio tries to capture the amount of trading a manager has done in a given year. There's a caveat, though. The ratio considers only the lesser of sales or purchases and divides that number by the fund's assets. So, the ratio may underestimate a manager's trading activity because it doesn't consider both sales and purchases. (The turnover calculation comes from the SEC, not Morningstar. We simply take this number from the fund's annual report.) A turnover ratio of 100% suggests that a manager has an average holding period of one year for the securities in the fund. That doesn't mean every single stock is traded within a year, but provides an estimate of much of the portfolio has changed during that time.

Why Use Turnover?
Despite its imperfections, examining a fund's turnover ratio is still worthwhile. It provides some insight into a manager's strategy. A turnover ratio of more than 100% suggests the manager does a fair amount of trading and has a fast-paced investment style. Momentum fund  Brandywine , for instance, has a turnover ratio of 210% because its managers buy and sell stocks quickly to capitalize on changing market conditions. On the flip side, a turnover ratio under 25% means the manager follows a buy-and-hold strategy.  Sequoia , which has held some of its stocks for decades, clocks in with a turnover rate of 12%. In practical terms, that means the fund changes roughly one in 10 of its holdings a year and leaves the other 90% of the portfolio intact.

It's also a good idea to keep an eye on how a fund's turnover has changed over time. A fund's PDF report on Morningstar.com provides its turnover ratio for the past 10 years so you can track the manager's trading pattern or see if a new manager has ushered in a new strategy. The number will fluctuate annually, but if there's been a huge change (say, from 10% to 115%), it could be a red flag that the manager is shifting his or her strategy and that the fund might no longer be appropriate for you. Keep in mind that turnover numbers from 2008 and 2009 might look a little unusual due to the market upheaval. Many respected managers, like Bruce Berkowitz of  Fairholme , traded a lot more than usual because stocks were at historically low valuations. Berkowitz sold many of his energy stocks in mid-2008 before commodity prices collapsed and bought a huge stake in low-priced  Pfizer . That boosted Fairholme's turnover ratio from 14% in 2007 to 81% in 2008. To the naked eye, such a big jump might look alarming, but Berkowitz didn't deviate from his investment strategy and was simply loading up on bargains he was finding during the market's lows.

Cost Implications
Perhaps most significantly, funds that trade a lot can be hard on investors' wallets. That's because a fund incurs transaction costs each time its manager buys or sells a stock. Not only do funds pay commissions to buy and sell, but they also incur so-called market-impact costs. Large funds rack up market-impact costs because it might take them a while to buy or sell securities; as they're doing so, they may ultimately obtain a less advantageous price than a smaller, more nimble fund would receive. Shareholders ultimately foot the bill for these costs through lower net returns. Of course, there are skilled managers, like Jerrold Senser and Thomas Wenzel at  MainStay ICAP Select Equity , who trade a lot and still deliver superb returns. For many average funds, though, excessive trading doesn't add much value.

Investors in taxable accounts also generally pay more in capital gains taxes with high-turnover funds. Each time a manager sells a stock for a profit, taxable investors are hit with a capital gains tax. The total amount an investor must pay can be quite steep if a manager sells a lot of winners in a given year. The tax toll can also be high if a manager sells an appreciated security he or she has held for less than a year, because short-term capital gains are taxed at the investor's ordinary income tax rate. That said, most investors won't be socked with high capital gains taxes for awhile because stocks faced such huge losses in 2008. Many funds have large tax-loss carryforwards, which offset future gains. However, investors making long-term decisions should generally steer clear of high-turnover funds in taxable accounts.

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Katie Rushkewicz Reichart, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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