Personal Finance: The Hazards of Investing In High Turnover Mutual Funds
Wednesday, December 17, 2014
Birmiwal Oasis illustrates the issues with mutual funds that have excessive "turnover". Turnover is the rate at which a fund's holdings change every year. A turnover rate of 50% means that half of the stocks held by a fund are completely replaced within one year. The typical managed mutual fund has a turnover rate of 85%. Index funds, which hold all the stocks in a stock market index and do not sell unless the index itself changes or in order to generate cash for redemptions, typically have turnover rates in the single digits. According to Morningstar, Birmiwal Oasis 's turnover rate was an astonishing 2,000%, meaning that its entire portfolio was replaced 20 times over the course of a single year!
In addition to generating excessive taxable gains in non-deferred accounts and driving up trading related costs, high turnover funds are very volatile. Due to their volatility, the actual return experienced by fund investors is often lower than the internal return of the fund itself because the fund’s volatility increases the likelihood that investors will buy and sell at inopportune times. Simply put, increased volatility increases the likelihood that investors will buy high and sell low, and pay more in the process.
John Bogle, the Founder of the Vanguard Group, Inc. and a champion of cost-effective investing, has commented on turnover. In a past interview, Mr. Bogle railed against "...funds (that turn) over at 100% or 200% annual rates, leading, among other things, to incredible tax inefficiency." He goes on to ask, "Would you do that with your own money? Do you think those managers would do that with their own money?" I can only imagine what Mr. Bogle would have to say about a fund with a 2,000% turnover.
Like Mr. Bogle, I feel that the best approach for most investors is to invest in mutual funds that are low cost and tax efficient due to low turnover. They should use these funds to pursue a long term strategy aimed at achieving a fair, market rate of return. Index funds exemplify this approach and are an excellent vehicle for implementing such a strategy. It is no accident that even Warren Buffett has dictated in his will that 90% of his remaining wealth at his death is to be invested for his heirs in an SP500 index fund such as the Vanguard 500 Index.
One can only wonder what is going through the mind of an investment manager who employs 20 different portfolios over the course of a single year. Calling such behavior a “strategy” strains the definition of the word. Avoid funds like Birmiwal Oasis and do not get on their careening rollercoaster ride; you will greatly increase your chances of achieving your long term investment goals and have a far less stressful investment experience to boot.
Readers with questions on personal finance and Social Security can email Joe Alfonso at [email protected].
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