More than 35 years ago, Warren Buffett made an enduring statement in one of his venerated shareholder letters, "Lethargy bordering on sloth remains the cornerstone of our investment style."1
Now, the Oracle of Omaha wasn’t promoting a lazy approach to investing. He was describing patience, allowing great companies to compound over decades rather than trading their way to mediocre returns.
It, in a way, was meant to delineate between research-based conviction and frenetic trading. Portfolio turnover offers a practical way to see that distinction in action: it reveals not only how often investments are traded, but what may be driving those decisions.
Portfolio turnover measures how much of a fund's holdings are replaced over a given period, typically a year. It’s measured by percentage.2 If a fund has 100% turnover, it means the entire portfolio was replaced once during the specified period. At 50% turnover, half the holdings changed. At 200%, everything turned over twice.
Calculating portfolio turnover is straightforward: take the lesser of total purchases or sales for the year, divide by average net monthly assets, and there’s the turnover ratio. A mutual fund holding $100 million in assets that buys and sells $50 million worth of securities has a 50% turnover ratio.
But the turnover ratio alone doesn't tell the whole story. Context is extremely important. An index fund tracking the S&P 500 might have a turnover ratio of 3-5% because the index composition rarely changes. An actively managed fund seeking undervalued small-cap companies might run at 60-80% turnover as opportunities emerge and fade. A tactical trading strategy could exceed 200%.
None of these numbers is inherently good or bad. Rather, they suggest a fund’s underlying philosophy.
Buying and selling stocks can come with costs outside of the actual share prices of the investment. That’s why you shouldn’t ignore portfolio turnover. Because over time, these “other” costs can add up and gnaw away at your returns.
First, there are trading costs such as bid-ask spreads, brokerage commissions, and market impact costs when large trades move prices. Say a fund with 100% annual turnover spends 1-2% of assets on these costs, while a fund with 10% turnover spends 0.1-0.2%. That difference can compound dramatically over time.
Then consider tax liabilities, particularly in taxable accounts. When a fund sells a winning position held for less than a year, the resulting short-term capital gain is taxed at the ordinary income rate, which is potentially as high as 37% at the federal level.3 Hold that same position for just over a year, and the long-term capital gains rate drops to 15-20%.4 Over many transactions, high turnover can also erode after-tax returns.
Research comparing high-turnover and low-turnover U.S. large-cap funds found that the average high-turnover fund showed a difference of 2.47 percentage points between pre-tax and after-tax returns, while the average low-turnover fund had a smaller gap of 2.21 percentage points.5 More broadly, analysis of Morningstar data shows that average tax drag over recent years has been around 1.5 to 2 times greater than the average expense ratio for U.S. equity funds, with investors losing roughly 1.8% of returns per year to taxes.6
But perhaps the most overlooked cost is behavioral. High-turnover strategies can make investors nervous during volatile periods. When investors see constant buying and selling, it's tempting to question whether the manager knows something they don't. That anxiety can lead to poorly timed redemptions, turning temporary drawdowns into a permanent losses.
Before we all rush to buy the lowest-turnover funds, let’s stop to reflect for a moment. Low turnover isn't a virtue in itself. Rather, it is the result of conviction, good and bad.
Imagine a fund that never sells a stock. The turnover ratio would be zero. But perhaps that fund held Blockbuster Video, Lehman Brothers, and other defunct companies. Companies change, markets change, and businesses evolve. Or disaster strikes. Sometimes, selling is exactly what conviction looks like.
So the question we should be asking isn't how low the turnover ratio is. It's whether the turnover reflects thoughtful analysis and decision-making or knee-jerk reactions.
Conversely, some low-turnover funds drift into complacency. They hold onto positions out of habit rather than conviction, creating what's sometimes called "closet indexing,” or charging active management fees while essentially hugging a benchmark.
Portfolio turnover can be viewed as a window into how a fund actually operates. It helps answer questions that marketing materials often fail to make clear:
For passive ETFs: Turnover should be minimal, reflecting only changes to the underlying index plus modest rebalancing. If a passive fund shows 30% turnover, there’s something rotten in Denmark. Maybe the index itself is poorly constructed, or the fund is using sampling methods that generate unnecessary trades.
For active strategies: Turnover can reveal the manager's time horizon. Funds focused on long-term compounders, such as businesses with durable competitive advantages and long growth runways, might have turnover ratios between 20-40%. They sell when a thesis is no longer tenable or a better opportunity arises, but they're not constantly churning. Tactical or value-oriented funds might run higher, perhaps 60-100%, as they are looking at shorter-term mispricings.
For quantitative strategies: High turnover (150%+) might be normal if the strategy systematically exploits small inefficiencies that require frequent rebalancing. The key question is whether those trades are generating returns that justify the costs.
What you're looking for is alignment. Does the turnover ratio match what the fund claims to do? A fund promising long-term investing that shows 150% turnover every year, like Lucy Ricardo, “has some ‘splaining to do.”
So what is the optimal turnover? There’s no magic number that answers the question. The right turnover depends entirely on strategy, market conditions, and investor circumstances.
It's about understanding that portfolio turnover is a means, not an end. It's a tool that should serve a larger purpose: building wealth through disciplined, thoughtful investing.
High-conviction investing doesn’t mean lethargy or frantic trading. It means making changes when analysis and evidence demand it and taking no action when they don't. It means knowing the difference between responding to new information and reacting to noise.
Portfolio turnover, properly understood, can help illuminate what camp a fund falls into. In an industry where activity can masquerade as sound strategy, it’s worth paying attention to.
At Motley Fool Asset Management, we've long believed in high-conviction investing, and our ETF lineup reflects that discipline in action. Explore our funds to learn more.