What should be every mutual fund investor's biggest concern?
Hopefully, you just said "fees." Because fees, in their various shapes and sizes, not to mention colors, have an unmatched ability to eat away at your precious investment dollars. That's why it's Foolish to invest in funds with the lowest expense ratios.
But, alas, there's another very important ratio to consider -- the turnover ratio.
Don't try this at home
Take, for example, ProFunds Large Cap Growth (LGPIX). According to Morningstar, this fund recently decreased its turnover ratio to 1,287% -- down from 1,288% during its previous period. That means the fund's manager has sold assets equal to 13 times the net assets of the fund.
ProFunds has often used leverage techniques in order to try and squeeze a bit more out of its holdings, so maybe it's no big deal. Maybe I'm just overreacting.
Actually, I'm not -- not a chance. When I see an astronomical turnover ratio like that, I'm alerted to three potential problems that have been shown time and again to destroy a mutual fund manager's chances of beating the market. Without further ado:
1. Higher taxes
OK, this is an obvious one. With each profitable trade, the fund manager creates a taxable event that must be passed on to you. The best scenario says that these transactions are going to mean more taxable income for you, the investor.
However, I'd say you're just as likely to end up with a loss if the manager is trading this much. Why, you ask?
2. Higher transaction fees
That's right -- because of higher transaction fees. I don't know about you, but each time I buy and sell a stock, I have to justify the commission I'm going to incur in the transaction. I don't get to trade for free, and I'd be willing to bet your mutual fund manager doesn't, either. Rather, fund managers incur commissions just like you and me. And those commissions are coming right out of the fund's assets, which means lower returns for you.
3. Lack of conviction
This is the hardest to quantify, but it concerns me the most. Studies have shown that three out of four mutual funds can't beat their respective benchmarks. I'm looking for mutual fund managers who believe in the stocks they're buying. If they don't believe in their picks, then we shouldn't believe in them, either.
The flip side
Now compare ProFunds Large Cap Growth with a fund that sports a rock-bottom turnover ratio -- Vanguard Growth Index (VIGRX). Both funds share four of their top five holdings -- Microsoft
Indeed, over the trailing three-year period, the Vanguard index has outperformed the ProFunds offering by more than three percentage points annually. (And I'd go back further, but ProFunds Large Cap Growth has only been around since 2002.)
The Foolish bottom line
Don't get me wrong: A higher-than-average turnover ratio won't necessarily preclude a fund from becoming great (or a "Champ," as we call them at the Fool), particularly if its manager delivers the goods on an after-tax basis. But even if such a fund is a Champion, it would be best to hold it in a tax-favored account.
That said, head fund geek Shannon Zimmerman, analyst of the Champion Funds newsletter service, pays close attention to mutual fund turnover when he's recommending a choice fund every month and the best kind of account to hold that fund in. If you'd like to see what Shannon's recommending, click here to give Champion Funds a free 30-day test drive. His championship picks are beating their benchmarks by nine percentage points, and there's no obligation to subscribe.
Ryan Angell isn't a big fan of asset turnover, but he thinks apple turnovers are pretty good. He owns shares of Microsoft and doesn't expect that to change for a long time. Microsoft is an Inside Value recommendation. Johnson & Johnson is an Income Investor pick. This message is brought to you by the Fool's disclosure policy.