If you're evaluating mutual funds, you should be evaluating their turnover ratios, too.
Turnover ratios measure how much buying and selling a fund does each year. If a fund has a total value of $5 billion and buys and sells $5 billion of securities in one year, its turnover ratio is 100%. Steep turnover ratios hit investors with a double-whammy: high commission charges for all those trades and taxable capital gains.
Published returns in glossy magazines typically incorporate commissions paid, but not taxable capital gains. In 1992, Stanford economists John Shoven and Joel Dickson found that a typical stock mutual fund can have up to 40% or more of its return eaten up by taxes.
A high turnover ratio doesn't necessarily mean you shouldn't buy a particular fund. According to Morningstar mutual fund data, the five top-performing mutual funds for five years in the late 1990s sported turnover ratios ranging from 115% to 753%. Just know that, in theory, the higher the ratio, the higher the tax burden and commission costs.
The Fool article "Five Fund Mistakes" will help you avoid some blunders as you evaluate funds.
Learn much more about the mutual fund industry in John Bogle's well-regarded book Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor. Learn more about investing in mutual funds in our Mutual Funds area, and zero in on our index fund information there.
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