Does Low Turnover Mean Greater Gains?

One important aspect that mutual fund investors tend to look for is the turnover ratio of potential funds. The turnover ratio of a fund represents how often they trade securities within the fund. Many growth funds utilize a high turnover investment strategy. Fund managers of this type of strategy are constantly looking for stocks that exhibits high growth potential. Therefore, they are selling stocks or not growing according to their desires and buying stocks that they believe could grow.

Other funds decide to implement a low turnover strategy. With this strategy, the fund investors research stocks extensively before selecting the ones they believe can grow over the long-term. They buy a great number of stocks at the beginning of the mutual fund and then hold the stocks over the long-term. If the companies that they choose grow during this time period, it benefits the investors of the mutual fund with growth as well. Here is a quick look at how turnover can affect gains:

Tax Efficiency

One thing to consider about the two strategies is the tax efficiency. Tax efficiency deals with the amount of taxes that you have to pay as a result of the actions of the mutual fund. For example, a mutual fund with low turnover will traditionally hold stocks for longer than a year. Then, when they are sold, the shareholders pay taxes on these gains at the long-term capital gains tax rate.

A high turnover fund, will often sell stocks in less than a year after buying them. When this happens, it will be treated as a short-term capital gain and will be taxable at that rate. Long-term capital gains are much more desirable from a tax perspective. The long-term capital gains rate is less than if you quickly sell the stocks. Short-term capital gains are taxed at your ordinary marginal tax rate and treated as regular income. Therefore, the more you buy and sell, the more taxes you will have to pay.

Commissions

Something else to consider about turnover ratio is the commissions that are involved. Buying and selling securities requires a commission to be paid along the way. The more you trade, the more commissions will be charged. A more actively managed mutual fund will typically have higher expense ratios and higher costs overall to the investor. Utilizing a more passive form of investment, can help you avoid paying extra fees as part of your investment strategy.

Investment Considerations

When you look at all the factors involved, it would appear that low turnover can help you secure greater gains after taxes. However, this may not be the case. When looking at returns for many different types of mutual funds, there is no direct correlation to greater gains as a result of low turnover. It ultimately comes down to which securities are selected and whether or not they grow on their own. Choosing a fund with low or high turnover is a personal choice and may not necessarily affect the gains of the portfolio overall.

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