Portfolio Turnover: What Industry “Experts'' Are Missing

Turnover is basically how much trading activity you have within a period of time. It is usually expressed as an annual percentage figure. Some will argue that the more a money manager trades, the more tax-inefficient the portfolio will be and the more tax the investor will pay. That is, it is assumed that more trading implies a higher effective tax rate on the gains you make.

Oscar Wilde famously said, “When you assume, you make an ass out of u and me.” Rather than imitate a donkey, let’s examine why the “turnover = taxes” argument isone of the most oversimplified and inaccurate ‘‘conventional wisdoms’’ in the investment industry.

First, some of the trading may be done specifically to reduce the annual tax burden to the client. For instance, if I own a stock, mutual fund or ETF whose price has declined, and there is a very similar security available, I may ‘‘swap’’ one for the other. As a result, the portfolio gets a loss on the sale for tax purposes, yet the portfolio is effectively unchanged. The new security is expected to perform similarly to the old security, so you have effectively garnered a ‘‘free’’ tax loss. That can be offset against taxable gains at some point, to negate the tax that a taxable investor would have to pay on some investment in the future. That is, the ‘‘tax loss’’ has a positive value to the portfolio.

Now, consider this: Your money manager runs what they consider to be two portfolios in one. The first is a group of holdings that the manager expects to own for over a year and probably much longer. If successful, these will be sold for long-term capital gains at some point. The other group of holdings is shorter term innature. In other words, this second group of holdings is less strategic and more ‘‘tactical.’’ That means that to the extent that the manager’s tactical work pays off, short-term gains will be generated. Any tax swapping or otherwise losing trades will offset those short-term gains for tax purposes.

What results is a portfolio that emphasizes long-term capital gains, but whose trading turnover is largely concentrated in the second group of trades. Statistically, the turnover of the fund will be higher, but there is still ample opportunity to achieve very high ‘‘tax efficiency,’’ where taxable investors pay only a small amount of capital gains each year.

So, drawing conclusions about tax efficiency of a money manager or other investment vehicle based solely on trading turnover is shortsighted and can cause you to bypass some very good potential investments and investment strategies. Keep that in mind as year-end portfolio tax planning rolls around.

© Sungarden Investment Research


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