Welcome back to another edition of Foolish mutual fund basics. This time, we're leaving behind the rarefied air of expense ratios for the taxing world of portfolio turnover.
But before we begin, I ought to mention that there was an error in last week's article. Morningstar's total returns account for expense ratios. So, when comparing a fund's performance to the index at Morningstar, don't subtract the expense ratio. (And thanks to the several readers who pointed this out to me.)
What it is
Now, let's talk turnover. Put simply, portfolio turnover is the purchase and sale of securities in a fund's portfolio. A ratio of 100%, then, means the fund has bought and sold all its positions within the last year.
Retired Vanguard CEO Jack Bogle calls excessive turnover a bogey that investors ought to avoid because of its propensity to limit returns. How? High transaction costs can unnecessarily boost expense ratios. And, just as bad, excessive trading can incur capital gains, which get passed through to investors and, ultimately, the taxman.
Shannon Zimmerman, Motley Fool GreenLight co-advisor and lead analyst for Motley Fool Champion Funds, explains that "... turnover matters because it's a short-form gauge of -- or proxy for -- tax-efficiency: The lower a fund's turnover, the more tax-efficient it's likely to be. That said . folks shouldn't lose the after-tax forest for the tax-efficiency trees. Being miserly with the taxman isn't a moral crusade, and if a manager with an above-average (or even high) turnover rate fund has gotten the market-beating job done over the long haul, I'm certainly willing to give his fund a look."
How it works
Unfortunately, not enough funds beat the market soundly while paying the taxman his due. Let's run through a comparison. First, consider champ T. Rowe Price New Horizons (FUND: PRNHX ) , which turns over just 24% of its portfolio annually. Over time, this fund has been a solid market-beater, with manager John Laporte outdistancing the S&P 500 by more than 5% annually over the past five years.
New Horizons is also highly tax-efficient, thanks to its lower turnover. According to Morningstar, taxes have cost investors only 20 basis points in returns over each of the past five years.
Not so with Lighthouse Opportunity (FUND: LGFTX ) , which turns over roughly 56% of its portfolio annually, and which, as a result, has lost 43 basis points of returns over each of the last five years. That's more than double the tax bite of peer New Horizons. Accordingly, Lighthouse is 83 basis points a year behind its rival over the same period.
Go under the hood
Checking for portfolio turnover is pretty simple, thanks to Yahoo! Finance. First, enter your fund's ticker at the main site. Then click on "profile" and scroll down to "portfolio turnover." There, you'll find the turnover ratio and the average for the type of fund you're seeking to buy.
With that information in hand, head over to Morningstar.com. Once again, enter the ticker for the fund you're investigating. Then click on "tax analysis" to check the estimated tax bite. You're looking for the "tax cost ratio," which shows the estimated cost of taxes to shareholders in terms of annual returns. A higher ratio suggests a greater tax burden for investors.
Follow the money
Remember, the best investors seek to buy great stocks they'll have to sell rarely. Or, in the case of billionaire stock picker Warren Buffett, never. Seek similar discipline from the mutual fund managers with whom you invest and you'll increase your chances of outsized returns while limiting visits from the taxman. It's a double whammy that will help you make the most of your money as you invest.
Interested in more moneymaking tips? Consider GreenLight. Shannon and co-advisor Dayana Yochim are offering 30 days of free access to the service right now. Click here to get started.
Fool contributor Tim Beyers, ranked 1,309 out of 13,830 in Motley Fool CAPS, rarely sells his stocks or his funds. Tim didn't own shares in any of the companies mentioned in this article at the time of publication. Get a peek at everything he's invested in by checking Tim's Fool profile. T. Rowe Price New Horizons is a Motley Fool Champion Funds pick. The Motley Fool's disclosure policy is a bargain at any price.