Investment Turnover Ratio
Investment turnover ratio, or simply portfolio turnover ratio, is a measure that expresses how often assets within a fund are bought and sold by the managers. It’s commonly used in the context of mutual funds or other pooled investment vehicles, and it provides an insight into the fund manager’s trading activities and investment strategy.
The formula to calculate the portfolio turnover ratio is:
Turnover Ratio = (Total of New Securities Purchased or the Amount of Securities Sold – whichever is less) / Average Assets Under Management
The result is often expressed as a percentage. A high turnover ratio, say 100%, could mean that the fund’s entire portfolio has been replaced over the course of the year. This might be indicative of an active management style where the fund manager frequently buys and sells securities.
On the other hand, a low turnover ratio suggests a more passive management style, which might involve a “buy and hold” strategy.
The turnover ratio can be useful for investors when considering the potential impact of transaction costs and capital gains taxes. High turnover ratios could lead to higher transaction costs and possibly more short-term capital gains, which are generally taxed at a higher rate than long-term gains. Therefore, a fund with a high turnover ratio may have a higher cost associated with it than a fund with a lower turnover ratio.
It’s important to remember that turnover ratio is just one aspect to consider when assessing a fund. Other factors like overall performance, risk level, investment strategy, and manager’s expertise should also be taken into account.
Example of the Investment Turnover Ratio
Let’s consider a mutual fund as an example:
Let’s say Mutual Fund A has $500 million in assets under management at the start of the year and ends the year with $600 million in assets under management. So, the average assets under management for the year would be $550 million (($500M + $600M) / 2).
During the course of the year, the fund managers bought $200 million in new securities and sold $150 million of securities. In this case, we take the lower of the two values, which is $150 million.
Then, the turnover ratio can be calculated as follows:
Turnover Ratio = ($150 million / $550 million) * 100 = 27.27%
This implies that Mutual Fund A replaces about 27.27% of its holdings every year. Given this relatively low turnover ratio, we can infer that the fund managers are more likely to employ a “buy and hold” strategy rather than active trading.
As mentioned before, a lower turnover ratio might result in lower transaction costs and fewer capital gains tax implications for the investors. However, it does not necessarily mean better overall performance. The fund’s performance should always be assessed in conjunction with other factors such as risk level, fund’s investment strategy, manager’s expertise, etc.