The Hidden Costs of High‑Turnover Funds and How to Avoid Them
By understanding and addressing the hidden costs of high-turnover funds, investors can substantially enhance their long-term financial outcomes. At Freedom Capital Advisors, Ron McCoy guides his clients through these nuanced financial decisions, ensuring portfolios are optimized for growth, efficiency, and tax minimization.
One key factor in wealth management that doesn’t always get the attention it deserves is portfolio turnover. When funds are constantly buying and selling investments, higher transaction fees, bigger tax bills, and hidden costs can quietly eat away at your returns. For those looking to protect and grow their wealth, understanding and keeping an eye on these expenses is a smart move.
Understanding the Impact of High Turnover
High-turnover funds—those that swap out more than their entire portfolio in a year—may chase quick wins, but that approach can backfire. Here’s why:
- Increased Transaction Fees: Every time a fund buys or sells, there are brokerage commissions and bid-ask spreads. These small fees can add up and take a bite out of your net returns over time.
- Capital Gains Tax Liabilities: More trading often means more short-term capital gains, which are usually taxed at higher rates than long-term gains. For high-net-worth investors, this can mean a larger tax bill each year.
- Operational Costs and Management Fees: Funds that trade a lot typically charge higher fees, since they need more research and oversight to stay active.
A 2022 Morningstar study found that high-turnover funds generally trail behind funds with less trading, mainly because of these extra costs. This shows why it’s important to pay attention to turnover when picking funds.
Source: Morningstar Research Report on Fund Turnover
Case Study: Turnover’s Impact on Long-Term Returns
Vanguard recently showed just how much these turnover costs can add up. Over 20 years, funds with high turnover (over 100% per year) lost about 2% annually in net returns to taxes and extra fees. By contrast, index funds with low turnover managed to keep a lot more of their gains for investors.
Take two portfolios, both starting with $1 million:
- Portfolio A: A high-turnover fund (100% turnover, 2% in annual costs)
- Portfolio B: A low-turnover index fund (10% turnover, 0.3% in annual costs)
Assuming both get an 8% annual return before costs, after 20 years, Portfolio A is worth around $3.2 million. Portfolio B, meanwhile, grows to nearly $4.3 million. That’s a difference of more than $1 million—just from minimizing turnover and extra expenses.
Source: Vanguard’s “The Case for Low-Cost Index Fund Investing”
Strategies for Minimizing Turnover Costs
Cutting down on the hidden costs that come with frequent trading is important. Here are a few practical steps Ron McCoy often shares:
1. Opt for Passive Indexing Index funds and ETFs are designed to match the market instead of actively picking stocks, so they naturally trade less. That means lower transaction costs, smaller fees, and less tax drag for investors.
2. Prioritize Tax-Efficient Fund Structures Some funds are built with taxes in mind, using strategies like tax-loss harvesting to help offset gains. These structures can reduce the tax hit that comes with higher turnover.
3. Evaluate Turnover Rates When Selecting Funds Always check a fund’s turnover rate—it’s listed in the prospectus or on most investment research sites. A turnover rate under 20% per year often means a more tax-friendly and cost-effective fund.
4. Utilize Separately Managed Accounts (SMAs) SMAs give investors more control and flexibility to limit trading and better manage when to realize gains or losses, which can help avoid unwanted tax surprises.
Actionable Tips for Investors
To help keep more of your investment returns, try these tips:
- Take time each year to review your portfolio’s turnover rates, trading costs, and after-tax results.
- Talk with your advisor about using tax-loss harvesting strategies to help offset capital gains.
- Think about consolidating your holdings into a smaller number of high-quality funds or ETFs to reduce unnecessary trades and make your portfolio easier to manage.
Ron McCoy’s Perspective
Ron takes a conservative, research-driven approach when managing wealth. He leans toward strategies and investments that help maximize after-tax returns and keep costs low. For investors who want to protect their wealth and see it grow over time, Ron often recommends low-turnover, tax-efficient funds and passive investment options.
