Look for funds with low turnover. Turnover is a measure of the amount of trading activity that takes place during a given period; turnover is shown as a percentage of the average amount of total assets in the fund. Turnover is calculated by adding the fund’s sales and purchases and dividing by two. High turnover, or excessive trading, increases the amount of taxes and transaction costs you will have to pay. Many costs associated with turnover are hard to quantify, and they are not, therefore, disclosed in the prospectus. Other costs that stem from high turnover include commissions (fees you pay the broker), bid-ask spreads (the difference between what buyers are willing to pay and what sellers are asking for in terms of price), and market impact costs (a jump in price where a manager tries to buy a large block of shares). Remember that each transaction generates a taxable event: the cumulative taxes can be very expensive.

A mutual fund’s turnover is described under the prospectus heading “Annual Turnover” (see Table 25.3). You want to have in a mutual fund that invests long term, consistent with the principles of good investing listed in this website. The more turnover a fund has, the more the investor will spend on transaction costs (not included in the total expense ratio). The more taxes the fund generates, the higher the fund’s returns must be to offset these expenses.

You should also look at the section entitled “Potential Capital Gains Exposure in the Returns: Tax Analysis.” You should avoid funds that have a high potential for earning short-term capital gains because short-term capital gains are taxed at the highest marginal tax rate.

Table 25.3
Morningstar Website: Turnover