We've already pointed out that the keys to good management are 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
Trading costs can weigh down fund performance. Virginia Tech professor Gregory Kadlec, who cowrote 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 pursue trades based only 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.
One look at Morningstar data showed that the average mutual fund had an annual turnover ratio of about 89%. That means the typical fund buys and sells nearly its entire asset base every year.
However, some funds on both ends tend to lean toward extremes. Commonly, you'll find a few funds with turnover of 1,000% or more -- suggesting a full replacement of stocks every month or even more frequently.
When you see a fund with such high turnover, the first question to ask is why the fund has to trade its holdings so much. All of that trading costs investors money. Typically, high turnover translates to higher costs, and higher costs make it more difficult to earn a market-beating return.
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, by 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 of 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 do, 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 and turn 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.
Next, let's look at an enemy of good funds -- style drift.