One of the benefits espoused by proponents of index funds is the low turnover rate. I thought I would explain just what portfolio turnover is, and the further provide some concrete evidence to really make you stand up and take notice.

What Is Portfolio Turnover?

Portfolio Turnover is a measure of how much buying and selling is taking place in a fund. It is defined as the dollar value of buys or sells (whichever is less) during a year divided by the total assets in the fund. It a mutual fund had $100 million in the fund and there were $50 million dollars worth of sales and $50 million worth of purchases (with those proceeds) in a given year, the turnover would be 50%. A turnover rate of 100% would indicate that the manager has effectively sold the entire portfolio and bought new holdings during the course of the year. Another way of viewing it is to say that a fund manger with portfolio that has a turnover rate of 50% has an average holding period of two years for each stock the manager buys. A portfolio that has a turnover rate of 100% has an average holding period of 1 year of each holding within the fund, etc.

Why Is It Important?

Two main reasons: 1) Trading Expenses and 2) Tax Drag.

The brokerage commissions a fund manager pays is NOT included in a fund’s MER. So the more trades, the higher the commissions, and the higher the drag on your returns. According to Suzanne Abboud, you can expect to add between 0.65% to 3.12% to your fund’s MER to get a better sense of your total cost!

Tax drag is the other biggie. Let’s assume that you have a taxable account portfolio that you are managing yourself. We will also assume a 33% Marginal Tax Bracket. Take a look at the following chart put together by a third party.

I’ll cut to the chase: A portfolio with lower performance, but low turnover managed to keep pace with a portfolio with higher performance, but higher turnover.