Historically, many Financial Advisors and Money Managers have linked a portfolio’s turnover ratio with being an indicator of how tax-efficient a portfolio, such as a mutual fund, might be. The common thought was a high turnover meant higher taxation. While this can certainly lead to higher taxes, if the portfolio is selling positions at a profit, it does not necessarily mean that the portfolio is tax inefficient or that it is a good measure of tax-efficient management. It may be a better indicator as to why a fund's internal management expenses are higher than other funds and may be more appropriate for measuring the cost-effectiveness of the portfolio manager and not tax efficiency. To understand this let’s look at what portfolio turnover is first.
The portfolio turnover ratio indicates the number of a portfolio’s positions that have been replaced over the course of a given year. Actively managed mutual funds typically have more portfolio turnover vs. index funds and exchange-traded funds (ETFs). This is because these types of funds rely on a manager’s decision making on portfolio positions and whether to hold them or sell them, depending on the mandated management strategy of the fund and market conditions. Index Funds and ETFs tend to have smaller turnover because these types of funds are attempting to mimic an index of securities or a specific theme of investment in securities. Indexes typically only reposition the portfolio of securities once a year. Thematic baskets of securities tend to remain consistent based on the theme of the investment, not the performance of the actual underlying securities in the investment. This supports the notion that index funds and many exchange traded funds tend to have lower turnover than actively managed mutual funds. An example of how turnover works is that a fund holding 100 securities and replacing 75 of them for one year would have a 75% turnover ratio. This could lead to higher taxation, but not always. It is important to also know that a turnover ratio can exceed 100% if the manager of the fund holds the positions for less than a year.
One might believe that higher turnover means higher taxation, but that is not definitively true and has been somewhat overused as an indicator of tax efficiency over the years. Taxes only occur if there are realized profits. That said, stocks that are sold at a loss in the portfolio are counted in the turnover ratio but reduce taxation by offsetting gains in other stocks that are sold. Therefore, a portfolio manager tasked with being more tax efficient can have a higher than expected turnover ratio with a low tax liability. It is important to note that a buy and hold strategy-low turnover will likely produce a more tax-efficient portfolio, but there are many other portfolio management techniques’ that can greatly reduce tax impact. We will not get into the portfolio management technique’s in this article, but other common techniques are loss offset trading, continual loss harvesting, gains-tilted investing and tax lot accounting.
It is important to remember that taxes are only paid on realized gains. That said, effective turnover is a more accurate indication of a portfolio’s tax efficiency. Effective turnover is a measure based on the percentage of accumulated unrealized capital gains that are realized and distributed on an annual basis. For the taxable client, total turnover (turnover ratio) is not as important as the frequency at which capital gains are realized. It is often difficult to find this statistical reference point for a fund, but if provided, it is a better way of evaluating tax efficiency of a portfolio.
Many mutual funds will provide their tax efficiency ratio on their websites and marketing materials. A tax efficiency ratio is calculated by dividing the annual tax-adjusted earnings by pre-tax earnings. Lastly, Morning Star often provides a Tax Cost Ratio for most funds it provides analysis on. This ratio measures how much a fund’s annualized return is reduced by taxes investors pay on distributions. This ratio is indicated from 0% to 5%. 0 % shows the fund did not have taxable distributions for the time and 5% indicates the fund was significantly less tax efficient.
Turnover Ratio is only a part of the tax efficiency equation of a portfolio. Looking at more direct ratios will provide a better insight into the tax efficiency of a portfolio or fund. The first place to look would be the fund manager’s mandate. Are they tasked with being tax efficient? Then looking at the turnover ratio, along with the other measures we discussed, will give you a better idea of the efficiency of the fund or portfolio.