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What Turnover Rates Mean to Investors

June 22, 1997|CHARLES A. JAFFE

Recently I attended a mutual fund industry conference where the top guns at some of the nation's leading fund companies complained that investors are too focused on the short term.

Talk about the pot calling the kettle black. These guys should pay attention to their own companies.

Turnover, the measure of how much of a fund portfolio gets churned in a year, is on the rise as the average fund manager continues to put less stock in buy-and-hold strategies. The average equity mutual fund will turn over about 85% of its portfolio this year, according to Lipper Analytical Services, up more than 10 percentage points from 1993.

More frequent trading means more brokerage charges. Commissions generally are not part of a fund's expense ratio, but studies have shown that funds with the highest average turnover also tend to have above-average costs.

At the same time, if turnover is caused by a manager aggressively ditching losers in favor of new and improved selections, increased trading keeps the portfolio fresh.

Turnover statistics can be telling if you know what to look for.

Your search for the meaning of turnover numbers starts with the fund industry's do-as-I-say-not-as-I-do attitude.

Short-term thinking leads more often to mistakes than to riches. Yet many good managers generate turnover by quickly cutting losers. Fund bosses say you pay for a manager's judgment and that investors--not managers--are the ones who need patience.

"The impact of turnover is tough to gauge because some low-turnover managers are superstars and others are slugs," says Robert Markman, who runs the Markman MultiFunds, which invest in other mutual funds. "Likewise, some high-turnover managers are hopped-up day traders, others are superstars."

To see why you can have winners and losers at both extremes, consider what turnover represents. To calculate turnover, funds divide either the securities purchases in the last year or the sales in that period, whichever is less, by the average monthly assets in the fund.

A 66% turnover rate, therefore, means that two-thirds of the fund's securities were bought and sold from year to year.

Buy-and-hold strategies typically would be characterized by turnover ratios of 30% or less, whereas anything above 100% reflects serious trading.

It's hard to tell whether a manager is trading to avoid roadblocks or because he or she has hit them. Likewise, low-turnover managers may be going in circles instead of going forward.

"Very little about turnover is predictive," notes Stephen M. Savage, editor at Value Line Publishing. "It's more like a trail of what a fund did. That makes it a better tool for reviewing performance than picking a fund in the first place."

For that reason, consider your fund manager like the driver of a race car. The turnover statistics suggest whether your driver is going in a steady line or weaving through traffic in a rough but fast course. You need to decide which kind of driver you want for your money.

When reviewing turnover statistics--available in fund reports, but also from the major data services--consider:

* Consistency. If a fund's turnover remains constant, management probably has not changed its style. If turnover jumps--particularly if performance falters--you have a sign of trouble.

"When a fund is lagging the market and the manager goes from an 80% turnover ratio to 140%, it's a sign that he is flailing around and trying to figure out where to go next," says Richard J. Moroney, editor of the Dow Theory Forecasts newsletter. "If he can recover quickly, or if he is shifting assets based on what he sees in the market, turnover will stabilize. If he just keeps hacking and doesn't catch up, you've got a different kind of fund than the one you started with."

* Tax implications. A high-turnover fund typically generates a bigger annual capital gains payout, which means a higher current tax bill for you. A buy-and-hold fund puts off most of its gains and reduces your current tax bill.

Studies show that in very general terms, funds with average to low turnover post better after-tax returns than faster-trading counterparts.

* Potential impact on performance. High turnover coupled with above-average expenses should make you nervous. The manager will need to generate returns big enough to pay for all of the fund's costs; that's hard to do consistently when trading and expenses take a deeper-than-average cut into returns.

Charles A. Jaffe can be reached by e-mail at jaffe@globe.com or at Boston Globe, Box 2378, Boston, MA 02107-2378.

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