Is Your Manager Trading Too Much?

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.

What Is Turnover?
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. 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.

It's also a good idea to keep an eye on how a fund's turnover has changed over time. 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.

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.

Morningstar Thailand Editorial Team