A Financial Revolution 

January 23, 2006
Turnover and Fund Returns

The February issue of Smart Money has an informative article about how a mutual fund’s turnover affects performance. Turnover represents the percentage of a fund’s investments that are sold each year. For example, a turnover rate of 84% – the average for large cap mutual funds – means that 84% of the stocks or other assets in the fund were sold during the previous year. A fund’s turnover rate can be greater than 100%. Rydex Large Cap Growth Fund (RYAWX) has a turnover rate of 2,018%, meaning it holds an investment for an average of 18 days.

When evaluating a fund as a potential investment, I usually look at turnover only because it has tax consequences – the more often a fund sells, the more potential to realize taxable capital gains that are distributed to fund holders. The Smart Money article points out that tax efficiency is not the only benefit of low turnover – low-turnover funds perform better than high-turnover funds. A study by Kevin Laughlin grouped all mutual funds into quartiles based on their turnover rates. Over 10 years, those funds with the lowest turnover rate returned an annualized 11.49%; those with the highest turnover rate returned 9.78%. Over 10 years, that's 197% return vs. 154% return. In addition, low-turnover funds had lower fees (less trades to pay for) – 24% lower than high-turnover funds.

The article argues that fund managers with low turnover are generally focused on the long term and look to invest in high quality companies. The average turnover rate of the low-turnover funds is 13%. That means they hold investments for an average of 7 years. 7 years! That takes conviction in your decisions. Hopefully these managers invest a great deal of time and effort to analyze the companies (would Rydex's managers invest time researching a stock that will only be held for three weeks.) Perhaps because of the effort required to find good long-term investments, these funds generally own fewer stocks, allowing the managers to focus on their best ideas (it’s easier to find a handful of stocks than 100 good stocks.)

If you want to follow this strategy, find funds with low turnover, low fees, and a limited number of holdings. The first two are easy – most mutual fund screens include them – the number of holdings is usually located in the prospectus or fund summary.

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