I have been looking at a very promising small-cap fund but have some reservations. Is there a significant disadvantage to purchasing a mutual fund with a very high turnover rate, say 200%? Also, the total expense ratio of 1.81% is higher than I usually prefer. Does this ratio take into account the turnover or are they separate quantities to be evaluated individually? -- Maria Preziosi
High turnover is not necessarily a bad thing. But high expenses can be hazardous.
A fund's turnover ratio is a proxy for how often a manager trades. The higher the turnover, the more a manager has traded securities in the fund. High turnover -- of say more than 100% -- can tell you a fund's investment strategy involves substantial trading. Low turnover says a manager is following more of a buy-and-hold strategy. For example, a fund that trades 25% of its portfolio each year holds a stock for an average of four years.
Value funds, which tend to buy stocks the manager feels are unloved and underpriced, generally have lower turnover than aggressive-growth funds. For example, the
Van Wagoner Emerging Growth fund, a well-known high-growth fund that's closed to new investors, has annual turnover of 353%, compared with 13% for the value-loving
More importantly, heavy trading -- illustrated by high turnover -- can be costly and eat away at your return. When a manager trades, you lose money to brokerage commissions and the bid/ask spread on the trade, which is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. Those costs come right out of a fund's net assets and are in addition to the administration and management costs reflected in a fund's expense ratio.
Unfortunately, funds are not required to quantify trading costs for investors, so you never really know what they add up to. That's why you should keep an eye on turnover when inspecting a fund.
But with small-cap funds, you should expect turnover and expenses to be higher than for funds that buy larger-cap stocks.
Small Stocks Can Be Unpredictable
Small companies, by nature, are younger and more unpredictable, which can force a manager to trade in and out of stocks more often. A little company six months from now can be very different from the one that exists today. It might be the leader of its small field or it could be out of business. A smaller company may not have the same staying power as an older one that dominates its business.
The average small-cap growth fund tracked by
has a turnover ratio of 124% compared with a 107% turnover rate for large-cap growth funds.
In general, you'll also see more pricing inefficiencies in the small-cap market, and managers will trade in and out of stocks to capitalize on those inefficiencies. A manager might be able to ride a stock for nice pop, sell it and then repurchase it when it falls back.
"A good manager with a good process can add value through turnover," says Bill McVail, manager of the
Turner Small Cap Growth fund (which is closed to new investors).
Small-cap managers can also be more aggressive in their approach to money management and might be quick to sell a stock sooner. Or, if they are committed to their small-cap objective, they may be forced to sell their winners when they turn into mid- and large-cap companies.
Some people will argue that high turnover means you could wind up with more taxable distributions from a fund. Such is not always the case. A manager who is an astute trader might be very good at realizing losses, which can be used to offset taxable gains. If you're worried about the taxes you'll pay on a fund, you should also check a fund's record of distributions.
You'll Pay More in a Small Fund
The expense ratio is another issue altogether.
The average small-cap growth fund has an expense ratio of 1.54%, compared with 1.24% for large-cap growth funds.
Small-cap funds usually have lower asset levels than their large-cap counterparts. With fewer dollars in the portfolios, small-cap funds have don't the same economies of scale. A small-cap fund will typically have fewer shareholders to bear the costs of managing the fund. Remember: These funds need to stay small so they can continue to invest in these smaller companies. The
Turner Micro Cap fund, for example, closed to new investors in early March when its assets reached a predetermined limit of $250 million.
Small-cap managers also will argue that these funds cost more to run because of the greater research costs. Very often, small companies aren't covered by many of the major brokerage firms and require more hands-on inspection.
"We have a team of 11 analysts. We have sector specialists in all our areas," says Turner's McVail. And his firm only manages $9 billion in all of its accounts.
If you're going to fret over these numbers, you should be more concerned with high expenses than high turnover.
Some research shows that high turnover doesn't have a direct relationship to a fund's expected returns.
Bryan Olson, director of
Charles Schwab's Center for Investment Research
, says the firm's research did not find any relationship between turnover and expected future returns.
In fact, if you look at the small-company funds tracked by Morningstar, some of the ones with high turnover ratios have the best three-year returns.
RS Emerging Growth, which is now closed to new investors, has a turnover ratio of 291%, but it also sports a three-year annualized return of 68.3%, the highest for the group through April 30. The
Van Wagoner Micro-Cap Growth fund, which is also closed, has a turnover ratio of 180%, double the 90% average. However, its three-year annualized return of 58.9% is the fourth highest of the group.
However, Schwab did find that the higher the expense ratio, the lower the expected returns. "Don't buy anything well above the average," says Olson. The average expense ratio for all small-company funds is 1.35%, according to
Morningstar's research director John Rekenthaler seconds that thought. "If someone starts throwing a 2% expense ratio at you, I would go find someone else."
A fund's return will reflect any money lost to trading costs as well as costs reflected in the expense ratio. So pitting one fund's long-term record against another will give you an apples-to-apples comparison of the bottom line after costs are deducted.
That's the best way to get started.
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