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How to Measure Investment Turnover and Why You Need to Do So

02/13/2019

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Investment turnover is one of those little-known investment terms that gets little love or discussion but plays a very important role in any portfolio. If you were to turn on a business or investing television segment, for example, you likely wouldn’t hear so much as a passing mention of turnover. Of course, investment panels on television are there for entertainment more than education. It’s like “Keeping up with the Kardashians” for people with a 401k.
Diving into detailed and nuanced topics like investment turnover is a quick way to get casual investors to turnover to a new channel. However, just because the talking heads on television don’t discuss investment turnover regularly, doesn’t mean the topic shouldn’t always be in the back of every investor’s mind.  Investment turnover plays an important role in portfolio construction, fee management, and tax planning.
This article will explain investment turnover, why investors need to be aware of this important figure, and how to calculate turnover for yourself.

What is Investment Turnover?

Investment turnover, commonly referred to as turnover ratio, is a figure that shows how much of an investment portfolio’s assets are sold or changed within a set time frame. This is usually expressed as a percentage over a quarter or an entire year. It’s important to understand that investment turnover is neither good or bad. The impact of turnover will vary based on each individual investor’s specific goals and investment needs. For some, high turnover may be something to avoid while others may chase investments that have high turnover ratios.
As a result of turnover, investors may find themselves on-the-hook for resulting fees and capital gains. Index funds and mutual funds incur costs as a result of turnover and this cost is passed onto investors.

Again, fees and capital gains taxes are not necessarily bad if the investment performance justifies those costs. However, some investors would prefer to avoid high fees and tax burdens. This is why understanding turnover ratio and how it relates to a specific investment or fund is important.

Why Do Investments Have Turnover?

Many long-term investors take a buy-and-hold approach to investing. These investors understand the old saying, “Time in the market beats timing the market.”
For that reason, it may come as a shock to some investors that the funds they are investing in are actually quite active.

Mergers/Acquisitions

Some causes of investment turnover are somewhat unavoidable for fund managers. One example of this would be mergers or acquisitions. This is a common occurrence in the stock market as companies merge or large companies acquire smaller companies. When this happens and a merging or acquired company has publicly traded shares, those shares are often purchased by the other company as part of the agreement.

From the investor standpoint, this transaction is a sale of assets just like any other sale of shares. Fees will be accrued and, if the stock was sold higher than when it was purchased, there may be capital gains taxes to consider. This type of scenario is almost impossible to avoid and it is one reason why even the most conservative investment funds still have some investment turnover.

Delisting or Financial Troubles

Another cause for investment turnover that is uncontrollable by fund managers is delisting or financial troubles like failing to make debt payments or going bankrupt. Financial troubles, like bankruptcy, often lead to a stock being delisted. Delisting is the process by which a stock is removed from the exchange where it was previously traded. In some cases, delisting may not mean the company is in trouble. For example, if a company was to go private then it would be delisted as the shares would no longer be a publicly traded company. If a stock runs into financial challenges, then its share price will likely begin to fall. For many stock exchanges, companies must maintain a minimum share price to continue being listed on the exchange. If this is not done, then the stock will be delisted.

In many cases, a stock may become essentially worthless barring a spectacular recovery by the company.
Regardless of why delisting occurs, shares being removed from an exchange will incur fees for investment managers who sell or remove the assets from their holdings.

Reconstitution

Finally, a common reason for investment turnover that is controllable by fund managers is called reconstitution. This is when a fund buys and sells shares to ensure that the total holdings of the fund appropriately reflect the goals of the fund.

Index funds are a great example to illustrate reconstitution. Imagine that an index fund has been designed to track a specific industry like financials, for example. This index should best follow the market movements of that industry. Therefore, it needs to be made up of the right selection of assets. If a single share were to grow or decline rapidly then it may put the overall composition of the index fund outside of its targeted goals. As a result, the fund would have to sell some assets and buy other assets in order to bring about balance that is in-line with the fund’s original goal. This is reconstitution and, as a result of these transactions, there would be fees and possibly even capital gains that must be passed on to investors.

How to Measure Investment Turnover

As mentioned, investment turnover does not necessarily be looked at as a good or bad thing. However, investors should be able to understand how to calculate investment turnover.
With this knowledge, investors will have a better understanding of the potential costs and risks associated with an investment. In turn, they will be able to make more educated investment decisions for their future.

Calculating investment turnover is not a complicated math equation so anyone should be able to do it with just some basic information about the fund in question.

Value Assets Held vs. Value of Assets Sold or Traded

All you have to do is look at the financial information for a fund to find the total value of assets held as well as the value of assets sold or traded. Once you have those two numbers, all you have to do is divide the number of sales by the total amount of assets held by the fund. This will give you the investment turnover ratio and it reflects how often each dollar of assets is sold or turned over.

A lower ratio means less turnover while a higher ratio means more turnover. One thing to make note of when you do this calculation is the period of time that you are analyzing. For example, if you are comparing two funds then you would want to make sure you are analyzing the same periods of time.

Getting the Annual Turnover Ratio

In addition, if you were analyzing quarterly numbers then you could multiply the ratio by 4 in order to get an estimated annual turnover ratio. Of course, past results are not always indicative of future performance, so you must recognize that multiplying a quarterly ratio is simply an educated guess rather than cold, hard facts.

This method also assumes that the assets under management by the fund remain the same throughout the entire year.

What Does Investment Turnover Mean to You?

Now that you know what investment turnover is, why it occurs, and how to calculate turnover – what does all of this mean to you as an investor?

How do you use this information to make more educated decisions for yourself and your family?

By understanding investment turnover and being able to calculate the ratio for yourself, you have a better idea of the costs that may come as a result of choosing to invest with the fund in question.

How you choose to look at those numbers will largely depend on your personal goals and investment needs. People who want to limit capital gains taxes and fees will be more drawn toward low investment turnover ratios. This would indicate that the investments are more conservative and the fund is less likely to incur fees or taxes as a result of frequent trading.

On the other hand, those who are looking for fast growth and are willing to accept the fees or taxes that may go along with that growth may be attracted to a higher investment turnover ratio.
Since the ratio is higher, this could indicate the investment strategy of the fund is more aggressive. As a result, there may also be more risk associated. For those with long term goals, investment risk may be less of a concern when compared to investors with short term goals who may be nearing a major life milestone like retirement.

What Are the Limitations of Calculating Investment Turnover?

An investment turnover ratio can tell you a lot about a specific investment. However, like many forms of investment analysis, turnover ratios can’t tell you the full story. Rather, investors should use investment turnover ratios as one tool in their toolbox while researching investment options. Market conditions and other challenges could temporarily cause investment turnover ratios to spike or fall in relation to the true average for a fund. All of this should be taken into consideration before choosing an investment.

If you have more questions about investment turnover, contact Linden Thomas and Company for more information.

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