What is this thing called "Mutual Fund Turnover?"

oneopinion left a comment and asks: "...why is high turnover a negative in a mutual fund and why do you set a turnover rate of 100% as the maximum?"

Thanks for the question. First, let me clarify, I did not set 100% as a maximum, and I do not have a maximum for new picks for my hypothetical portfolios. I do, however, prefer low turnover so lower expenses or much better long term performance would be necessary for me to choose a fund with high turnover over a comparable choice.

The question was why?

The hypothetical portfolios I have been tracking are for a non-retirement account so any capital gains would result in hypothetical taxes owed and higher turnover is more likely to lead to more capital gains

Morningstar.com defines turnover ratio:

"This is a measure of the fund's trading activity, which is computed by taking the lesser of purchases or sales (excluding all securities with maturities of less than one year) and dividing by average monthly net assets. A turnover ratio of 100% or more does not necessarily suggest that all securities in the portfolio have been traded. In practical terms, the resulting percentage loosely represents the percentage of the portfolio's holdings that have changed over the past year. A low turnover figure (20% to 30%) would indicate a buy-and-hold strategy. High turnover (more than 100%) would indicate an investment strategy involving considerable buying and selling of securities. Morningstar does not calculate turnover ratios. The figure is culled directly from the financial highlights of the fund's annual report."

The Motley Fool sums it up thusly:

"Turnover Rate and Taxes. A fund's turnover rate basically represents the percentage of a fund's holdings that it changes every year. A managed mutual fund has an average turnover rate of approximately 85%, meaning that funds are selling most of their holdings every year. Because buying and selling stocks costs money through commissions and spreads, a high turnover indicates higher costs (and lower shareholder returns) for the fund. Also, funds that have large turnover ratios will end up distributing yearly capital gains to their shareholders. Shareholders will have to pay taxes on these gains, and paying these taxes can be a real killer. Keep an eye on the turnover rate of any fund you own, and look to own funds with low (preferably no higher than 25%) turnover rates. (Index fund turnover is around 5% or lower.)"

Emphasis added.

I have no idea why fool.com claims that index fund turnover is 5% or lower. In my portfolios of index funds and ETFs almost all the funds have turnover much higher than 5%.

Take VIGRX Vanguard growth index. It has a turnover ratio of 28%. Not bad, but nowhere close to 5%.

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