What is annual turnover ratio means

The annual turnover ratio is a financial metric that measures the frequency with which a mutual fund or exchange-traded fund (ETF) replaces its investment holdings over the course of a year. It is a percentage that indicates the proportion of a fund's portfolio that has been actively managed or traded during the year. This ratio is important for investors to understand as it impacts the fund's costs, performance, and tax implications.

1. Calculation: The annual turnover ratio is calculated by dividing the greater of purchases or sales of securities by the average assets held by the fund over the same period. For example, if a fund has $100 million in purchases or sales and an average of $500 million in assets held during the year, the turnover ratio would be 20% ($100 million / $500 million).
2. Active vs. Passive Funds: Active funds, which are managed with the aim of outperforming the market, typically have higher turnover ratios as they engage in more frequent buying and selling of securities. In contrast, passive funds like index funds have lower turnover ratios since they track a specific market index and do not actively change their holdings.
3. Implications: A higher turnover ratio can lead to increased costs for the fund due to trading fees and commissions. These costs are ultimately borne by investors, potentially impacting the fund's overall performance. Additionally, high turnover may result in short-term capital gains, which are taxed at the investor's ordinary income rate rather than the more favorable long-term capital gains rate.
4. Investor Considerations: Investors should consider the annual turnover ratio when evaluating mutual funds or ETFs. A fund with a high turnover ratio may be more suitable for investors seeking active management and potential higher returns, but it may also come with higher costs and tax implications. Conversely, a fund with a lower turnover ratio may be more suitable for investors looking for a passive, cost-effective investment option.

Understanding the annual turnover ratio helps investors make informed decisions by providing insights into the fund's investment strategy, costs, and potential tax implications.