At first blush, exchange traded funds (ETFs)—and mutual funds for that matter—are pretty simple animals. They represent diversified baskets of various assets that can be bought or sold by any investor. That simplicity has helped ETFs grow to a staggering $3 trillion in assets across the globe. But even in that simplicity, there are a few things that investors need to be aware of.
One of the biggest is the “silent fee” of asset turnover.
Turnover can end-up costing investors’ big time. From lower returns to higher taxes and higher expenses, turnover can really do damage to a fund’s underlying performance. And it’s a concept that most investors are blissfully unaware of—even in staid index funds. Luckily, here at ETFdb, we’ve prepared a basic guide that should help most investors get a handle on turnover and how to eliminate its effects on their portfolios.
Turnover Basics
The nitty gritty of turnover comes down to the purchase and sale of securities in an ETF’s portfolio. It’s basically a measure of the fund’s trading activity; how many shares the manager is buying & selling. Every time a fund manager sells then buys, it’s upping its turnover ratio. You can calculate portfolio turnover by taking the total of new securities purchased or the amount of securities sold—whichever is less- and dividing that by the total net asset value (NAV) of the fund. Typically, turnover is expressed as percentage and represents a 12 month period of time.
A turnover ratio of 100% means the ETF or mutual fund has bought and sold all its positions within the last year. A relatively low turnover ratio—20% or 30%—indicates a buy & hold strategy. A high turnover ratio—100%+ -would indicate an investment strategy involving more trading than holding.
And while you may say, “who cares if my ETF or fund has a high turnover rate?” The truth is, it can be a big deal.
The Issues With High Turnover Funds
To start with, every time an ETF buys or sells a stock, bond or whatever, there is a transaction cost. Even for large institutional investors and fund sponsors, it’s not free to trade. The more times an ETF churns its portfolio, the more in fees the fund is racking-up. What’s more is that these transactional brokerage fees are not included in the calculation of a fund’s operating expense ratio listed in the fund’s prospectus. These costs in a high turnover portfolio can be a pretty significant additional expense. One that ultimately, reduces investment returns.
And while a fund can “guess” on what it will spend on transactions, there are other expenses it can’t gauge. Items like wide bid-ask spreads when it trades or unfavorable market conditions when it sells can vary wildly have a huge impact on its costs.
As if that wasn’t enough, high turnover can hurt in another way when the taxman cometh.
Just like when you sell a stock, you need to pay short or long term capital gains tax on proceeds. When a high turnover fund is constantly selling assets, it’s racking-up short and long term gains. Gains that will ultimately be paid out to its investors. Those investors will need to pay taxes on those gains come April 15th. Generally, high turnover funds end up paying out mostly short term capital gains, which pegged to ordinary income tax rates, investors could be hit with an unexpected tax bill.
Index ETFs Aren’t Immune to Turnover
While most bread-n-butter indexes and their respective ETFs—like the S&P 500—are generally low turnover, that isn’t always the case. Many index ETFs—especially niche products—turnover their holdings multiple times a year as the index changes. Small and midcap ETFs are notorious for this as firms have the propensity to be bought out or go out of business much easier than mega- or large-caps. Certain sector ETFs are prone to this as well.
Also having high turnover ratios are many of the new smart-beta ETFs being introduced over the last few years. Smart-beta funds use various screens and measures to create index beating portfolios. However, the constant screening does create more portfolio churn as stocks may no longer meet the ETFs requirements for inclusion.
Index ETFs can also suffer from temporary high turnover ratios. As fund sponsors continually look to slash expense ratios, many have begun switching to lower cost-to-license indexes. Vanguard reconfigured more than 20 of its ETFs back in 2012, while iShares is in the process of switching four of its funds. These sorts of events can create instant high turnover ratios—and the headaches that come with them.
And while, historically, many index ETFs have been able to avoid paying out capital gains due to turnover—thanks to the creation/redemption basket process—many fund’s sheer size makes that almost impossible. Meaning, investors in many formerly efficient funds may be getting dinged in the future.
What To Do About Turnover In ETFs
While turnover in even the most boring ETFs is a necessity, it doesn’t have to be a portfolio killer. To start with, investors can focus on the ETFs with the lowest turnover ratios. These funds will better track their indexes and perform better as the transaction costs associated with turnover are mitigated. Turnover ratios can be found in many ETFs sponsors websites as well as the fund’s prospectus.
Additionally, by placing many niche or high turnover ETFs into a tax-deferred or tax-free vehicle, like a Roth IRA or 401(K) account, the effects of capital gains can be eliminated.
The Bottom Line
Portfolio turnover really is the “silent fee.” Funds that continually buy or sell securities can wreck a portfolio’s return over time. Higher taxes, fees and underperformance await investors that fail to manage turnover and asset churn in an efficient manner.
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Disclosure: No positions at time of writing.
