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Tips for Tracking Turnover

When choosing a mutual fund, you should particularly look for two things: a track record spanning both good and bad market environments, and a long-tenured manager or management team. But other, smaller clues to a mutual fund's character shouldn't be overlooked, either -- especially a fund's annual turnover.

Out with the old, in with the new
A recent Morningstar conference in Chicago discussed how trading costs can weigh down fund performance. Virginia Tech professor Gregory Kadlec, who recently co-authored an academic study on the subject, noted that every dollar of fund trading costs lowers a fund's value by an average of $0.42. Kadlec also stated that large trades driven by fund inflows and outflows do the most harm, while small discretionary trades actually benefit funds.

It's easy to see how accommodating investor cash flows would hinder a manager's overall goal of maximizing fund returns. Ideally, managers would only pursue trades based on their overall investment strategy. But because open-end mutual funds are designed to let investors buy in and sell out at will, managers must deal with the logistical issues of inflows and outflows as well.

But what about a fund that deliberately employs a high-turnover strategy? When does turnover start to eat into investor returns? A quick look at some Morningstar data can show us where some actual mutual funds rank on the turnover scale.

Off-the-charts trading
According to Morningstar, the average mutual fund has an 89% annual turnover ratio. However, some funds on both ends tend to lean toward extremes. The chart below shows Morningstar's current five highest-turnover funds.


Annualized Turnover

Direxion Commodity Bull 2X Fund (DXCLX)


Direxion HCM Freedom Fund (HCMFX)


Direxion Spectrum Equity Opportunity Fund (SFEOX)


Rock Canyon Top Flight Fund (TOPFX)


Access Flex High Yield Fund (FYAIX)


Source: Morningstar Principia.

Yikes! That's a lot of buying and selling. That 8,528% turnover figure means that the Direxion Commodity Bull 2X Fund has been buying and selling its entire asset value about once every four days. And while there's no arguing that holdings like Marathon Oil (NYSE: MRO  ) and United States Steel (NYSE: X  ) have contributed to its success, why does the fund have to trade those holdings so much? All of this trading costs investors money. These five funds' average expense ratio is 2.17%, significantly greater than the average fund's 1.4%.

A happy medium
Of course, if a fund's turnover is too low, management may be making too few active trading decisions. A buy-and-hold strategy may make sense, but a reasonable amount of buying and selling shows that management is doing its job, selling positions that have reached their target price to buy new stocks with more upside potential.

So how do you know whether your fund's turnover is reasonable? There's no magic number, but for large-cap funds, you generally want to beware funds with more than a 100% or 150% annual turnover rate. Of course. many fine funds skillfully follow aggressive trading strategies; they may have turnover north of 200%, yet still perform well. Just make sure you know that these funds may incur extra trading costs.

Small-cap funds tend to have a slightly higher turnover than their larger-cap cousins, so Fools should cut them a bit more slack. Turnover of 150%-200% is common here, but watch out for anything greater.

In the end, excessive turnover can eat away at returns, turning good funds mediocre. It may not be one of the first factors investors review when evaluating funds, but turnover shouldn't be ignored. By checking how often your fund's management is buying and selling its holdings, and noting any sudden changes in turnover, you'll be much less likely to encounter unpleasant surprises down the road.

More Foolishness:

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Fool contributor Amanda Kish lives in Rochester, N.Y., and does not own shares of any of the companies or funds mentioned herein. The Fool's disclosure policy prefers apple turnovers.

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