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I learned a harsh lesson about portfolio turnover during a recession. I was forced to pay capital gains taxes on distributions of a long-term mutual fund holding, even though I didn't sell any fund shares and even though the fund value had dropped more than 20% that year.
This experience taught me about portfolio turnover and related expenses, including taxes (along with the generally wise and tax-efficient approach of purchasing mutual funds for tax-advantaged accounts, not taxable ones). Since then, I have paid more attention to this notion, not in fear of turnover but recognition of its potential costs and benefits.
So, what is portfolio turnover and why does turnover matter?
Portfolio turnover is the frequency of changes in an investment portfolio. Generally, it is expressed as a percentage and measured by taking the value of securities purchased (or sold, whichever is lower) in the past 12 months and dividing by the total asset value.
Low portfolio turnover means that there were few changes to a portfolio and high turnover means that there were many changes. Portfolio turnover applies to mutual funds (as mentioned in my example) but also applies to managed portfolios and investment services as well as my own investment portfolio.
Mutual Fund Portfolio Turnover
Actively managed funds tend to have higher portfolio turnover than passively managed (index) funds. Generally, securities for actively managed funds are chosen to fit within a fund's investment strategy and deliver out-sized returns. When a stock falls out of favor or becomes too overvalued, a fund manager likely replaces the stock with a more promising one, resulting in portfolio turnover.
Index funds simply match a certain index or broad definition (such as all U.S. stocks) so new securities are added only when the index is updated. However, some indexes are updated more often than others, leading to higher-than-usual portfolio turnover for an index fund.
A few examples illustrate portfolio turnover, which can be found in a fund prospectus or fact sheet:
Fund Name/Type of Fund/Turnover Ratio/Expense Ratio
- Vanguard 500 Index Admiral Shares (VFIAX) – Index – S&P 500 – 2.7% – .05%
- Vanguard PRIMECAP Fund Admiral Shares (VPMAX) – Actively managed – 10.8% – .35%
- Vanguard FTSE Social Index Fund Investor Shares (VFTSX) – Index – FTSE Social – 14% – .27%
- Janus Global Life Sciences Fund (JNGLX) – Actively managed – 44.8% – .84%
- Fidelity MidCap Value Fund (FSMVX) – Actively Managed – 69% – .83%
- Pax World Small Cap Fund Individual Investor Class (PXSCX) – Actively managed – 167% – 1.24%
- Spartan® Mid Cap Index Fund (FSCKX) – Index – Russell Mid-Cap – 15% – .09%
You can see then that index funds tend to have lower turnover while actively managed funds are likely to have much higher turnover.
Choosing and updating securities for a mutual fund holds the potential to deliver out-sized returns. However, the portfolio turnover associated with this process can raise investor costs in a couple of ways: 1) trading fees are generally higher because more transactions take place, affecting investment returns and 2) realized capital gains are passed through to fund shareholders, triggering tax liability for investors in taxable accounts, reducing after-tax returns.
Managed Portfolio Turnover
Portfolios managed by outside advisors, including robo-advisors like Betterment and FutureAdvisor, also experience turnover when underlying securities are bought and sold for rebalancing and tax loss harvesting purposes. Model portfolios could also be updated for various reasons that include an investor's change in risk tolerance (resulting in a new asset allocation) or an advisor's change in its investment approach (such as Betterment's tweaking of its portfolio optimization).
Transactions occur frequently as portfolios are rebalanced as often as daily and tax loss harvesting occurs throughout the year. Fortunately, robo-advisory portfolios tend to hold commission-free ETFs, largely avoiding trading costs.
Tax loss harvesting involves selling securities at a loss in order to counteract capital gains that may occur due to rebalancing (or other reasons). So, there may be limited tax consequences associated with managed portfolio turnover, particularly if you opt for tax loss harvesting services. Still, investors should be aware that portfolio turnover happens inside of managed portfolios and there may be costs associated with this turnover.
Your Own Investment Portfolio Turnover
Your own investment portfolio experiences turnover when you buy and sell securities. You may have valid reasons for trading frequently, but should be aware of the trading costs and potential tax consequences of high turnover.
Typically, you'll incur trading costs of $4.95 to $9.99 on individual stocks and non-commission-free ETFs, and as much as $75 on certain mutual funds depending on your brokerage firm. If you trade too frequently, you may get dinged with early redemption charges on mutual funds, including those that are categorized as no-load, no-transaction-fee funds.
Depending on your tax bracket, and whether you trade frequently in tax-advantaged or taxable accounts, sales of securities may generate capital gains taxes. Minimizing your portfolio's turnover can help you avoid unnecessary taxes and allow you to build wealth more effectively.
Notably, though, certain types of selling can benefit you. For example, selling stocks for a capital loss and reinvesting in more promising securities can offset gains.
Further, some investors churn their portfolios on purpose in order to raise the cost basis of their holdings as a tax-planning strategy. They plan their annual income carefully to maintain a low tax bracket, sell selected stocks to receive 0% capital gain tax treatment, and then repurchase these securities at the going rate, increasing the cost basis. Future capital gains will be calculated using this higher cost basis, minimizing gains for tax purposes. So, in some scenarios, well-planned portfolio turnover can save money.
I learned the hard way about portfolio turnover and its consequences. But now that I understand the potential consequences of portfolio turnover, I can plan more carefully and take advantage of its benefits while minimizing expenses.
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