A mutual fund's asset turnover ratio is a lot like the inventory turnover in a corporation. Both tell you a lot about how the company does its business: quickly with lean profits, or slowly with more gain overall. In mutual funds, the turnover ratio affects both fund performance and the overall tax burden on investors. Savvy investors understand the turnover ratio at the individual fund level and in a broader context.
Asset Turnover Ratio Defined
In a mutual fund, the asset turnover ratio is the percentage of a fund's assets that have changed over the last year. In simpler terms, it is a measure of how many holdings would be different if you looked at last year's portfolio and this year's portfolio side by side. Typically expressed as a percentage, the turnover ratio also reflects the average time that fund managers keep an asset. Turnover of 50 percent means that half the portfolio is different now than it was last year, and that management holds most assets for about two years, on average.
Asset Turnover Ratio and Fund Performance
Trade activity is a built-in part of the asset turnover ratio. After all, there is no change in investing without buys and sells. These trades can affect the fund performance in two ways. First, by selling poor performers and buying better assets, the fund manager hopes to improve the overall value of the fund. This translates to higher share prices and/or dividends for you as an investor. On the other hand, each trade comes with costs: fees and commissions that are simply part of trade transactions. The more trades, the higher the cost of running the fund. This can translate into lower overall returns for investors.
Asset Turnover Ratio and Taxes
Turnover ratio also affects how much tax investors pay. Mutual funds are pass-through entities. They must distribute all capital gains to investors, and investors pay tax on that income. Funds with higher turnover ratios may have more frequent gain distributions. In addition, more of that gain may be short-term and taxable at ordinary income rates, rather than the more favorable long-term capital gain rate. However, while lower turnover funds may hold assets for a long time and generally always qualify for the long-term capital gain rate, the gain distributed may be fairly high one year and very low another. This is frustrating for investors who would prefer to have more control over when they realize -- and pay tax on -- their capital gains.
Asset Turnover Ratio in Context
As with all performance ratios, asset turnover should be analyzed in context. Changes to asset turnover over time within the fund may reflect changes to management philosophy and strategy, and those adjustments may be good or bad -- a growing turnover ratio may not be bad if the overall fund performance improves. If an investor is comparing two similar funds, however, differences in turnover ratio can pinpoint issues with management or fund costs that might influence a purchase decision.
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