What is Portfolio Turnover? Definition, Examples and Pros and Cons

Portfolio turnover measures how actively a fund’s assets are bought or sold within a designated timeframe. This metric is pivotal for investors evaluating mutual funds or similar financial instruments. Typically calculated over 12 months, it involves determining either the total new securities purchased or the number of securities sold (whichever is lower) divided by the fund’s total net asset value (NAV). A high turnover indicates more frequent trading by fund managers.
Why portfolio turnover matters

Portfolio turnover directly affects investors through higher fees attributed to increased trading activity. A high turnover rate often leads to elevated transaction costs, impacting the fund’s returns. Additionally, increased trading generates capital gains taxes, distributed to investors, potentially causing tax liabilities.

Actively managed funds usually exhibit higher turnover rates compared to passive funds like index funds. Growth mutual funds and actively managed funds are prone to higher turnover due to frequent buying and selling.
Managed funds vs. unmanaged funds

The ongoing debate between advocates of managed and unmanaged funds, particularly index funds, underscores the performance comparison. Studies often showcase that actively managed funds might underperform compared to benchmark indices like the S&P 500, as reported by S&P Dow Jones Indices and Morningstar.
Factors affecting portfolio turnover

Higher turnover rates don’t necessarily equate to superior returns. While some actively managed funds outperform their benchmarks, not all higher-cost funds deliver better results. Managers maintaining low-cost strategies via fewer portfolio adjustments often yield successful outcomes.

High turnover portfolios often generate significant capital gains distributions, potentially impacting after-tax returns for investors. Investors focused on minimizing tax liabilities should consider the impact of turnover rates when evaluating fund options.

An illustrative example helps understand portfolio turnover calculation: If a portfolio begins at $10,000, ends at $12,000, with purchases totaling $1,000 and sales totaling $500, the turnover is calculated by dividing the smaller amount (buys or sales) by the average portfolio value. In this example, a 4.54% turnover signifies the fund’s activity.

A high turnover rate can be influenced by various factors such as the investment strategy of fund managers, market volatility, changes in economic conditions, and the level of active management within the fund.

Not necessarily. While high turnover can increase costs and taxes, there are instances where higher turnover funds might outperform due to effective trading strategies and the potential for greater returns.

Higher portfolio turnover often leads to increased capital gains distributions, potentially resulting in higher tax implications for investors. This can impact the after-tax returns on investments.