A Recipe for Bad Returns

Have you set yourself up for bad returns?

If you own mutual funds, you won't know the answer to that question unless you know your fund's turnover ratio. Do you?

First things first
Of course, you can't know whether your fund's turnover ratio is high until you know what a turnover ratio is: It measures the percentage of a fund's assets that have traded over the past year. Quite shockingly, the average mutual fund now has a turnover ratio of 100%, according to Vanguard founder John Bogle.

That means it holds the stocks in its portfolio for less than one year on average.

Bogle lamented this recent phenomenon last February:

All of this frantic turnover, of course, cannot possibly help our fund shareholders as a group. After all, most fund trading takes place with other funds and therefore cannot advance the interests of our owners in the aggregate. Indeed, to state the obvious (again), such trading must -- and does -- dilute the returns of our owners.

That's the case for a couple of reasons. First, high-turnover funds generate substantial trading costs and capital-gains tax bills that will take a bite out of your take-home returns. You can mitigate this effect somewhat by holding a high-turnover fund in a tax-sheltered account such as an IRA, but, as a 1998 study of 1,223 funds by Dr. Craig L. Israelsen (then of the University of Missouri) found, you may still come up short.

Seriously short
As Israelsen showed, "Mutual funds with a turnover ratio over 60% had, on average, lower return, a lower current Morningstar rating, lower net assets, higher expense ratios, less manager tenure, lower yield, and a smaller front-end sales load."

In other words, in addition to lower average returns, a high turnover rate also indicates that a fund has other serious problems, including an inexperienced manager and higher costs.

What does a high-turnover fund look like? As this table shows, they look and sound a lot like any other fund:

A new hope
With thousands of stock mutual funds to choose from, it's important to choose the ones that fit your time horizon, risk tolerance, and asset allocation, but also the ones executing sound investment strategies for your -- and only your -- benefit.

In most cases, that means you're looking for a fund that has:

• Low expenses.
• Low turnover.
• Tenured managers who have their own money invested in the fund and have proven track records.

If you need help finding funds that fit your investing style, consider a free trial of Motley Fool Champion Funds, the Fool's mutual fund newsletter service.

Advisor Amanda Kish whittles the thousands of available funds down to one recommendation each month and explains, in plain English, the ins and outs of the chosen fund. You can see what she's recommending today by joining Champion Funds free for 30 days. There is no obligation to subscribe.

This article was originally published Jan. 8, 2008. It has been updated.

Fool contributor Todd Wenning likes pineapple turnover cake, but not high-turnover funds. He does not own shares of any company mentioned. Coach is a Motley Fool Stock Advisor recommendation. The Fool's disclosure policy is scrumptious.