Writing about mutual funds over the years has given me insights into various trends. One of them is the tendency of Fidelity’s sector and industry funds to show good five-year annualized performance. Not every offering from the fund giant beats its peers and prudence is certainly required when considering investing in any fund, but I have seen Fidelity Select funds beat their peers in several categories.

This is the positive.

The negative is the funds’ turnover ratios. Turnover ratios measure how frequently a fund’s holdings change, or “turn over.” A turnover ratio of 0% means the portfolio has not changed at all over the past year. A turnover ratio of 50% means the equivalent of half the portfolio has been changed. Higher turnover ratios, say 100%, imply an even higher number of changes.

Turnover matters because it is a cost. Mutual funds are pooled investments. You, me and other investors throw our dollars into a pot and ask a professional manager to invest the money for us. Costs incurred by the manager come out of our money. Some of these costs, such as salaries, are covered by the expense fee. Transaction costs are commonly viewed as being an additional expense. Every time a manager buys or sells a stock, we shareholders pay the commissions. The more a fund’s holdings are turned over, the more we pay and the less we realize in terms of performance.

Investors holding mutual funds in a taxable account incur an additional levy. To the extent that short-term capital gains are both realized and not offset by losses, the tax bill for shareholders rises. Each dollar of short-term capital gains passed along reduces the shareholder’s realized return by his or her marginal ordinary income tax rate. Put another way, each $1,000 of short-term capital gains distributed to a shareholder in the 28% tax bracket reduces his or her net annual return by $280.

Not all turnover is bad. If a security is no longer attractive, the fund manager should sell it. Similarly, if the manager knows of a truly better investment, he or she should make the appropriate change. We are, after all, hiring the manager to make good decisions.

The problem occurs when a fund’s turnover is high. High turnover ratios imply the manager is trading, not investing. Trading is fine if the fund is promoted as following an aggressive, short-term strategy. Yet most funds are not promoted this way; they are promoted as long-term investment vehicles. Investors are encouraged to buy and hold them, even when the fund itself has considerable turnover.

Fidelity is guilty of this contradiction. The company’s Select sector and industry funds come with a 0.75% rear-end load. The charge is levied if one of these funds is sold within 30 days of purchase. It’s a classic case of “we don’t want short-term traders, but look the other way as we trade frequently.” (I cannot say with certainty that the load applies to every Fidelity Select fund, but every one of these funds that I’ve looked at does have the redemption fee.)

Though I’m singling out Fidelity, many other fund families are guilty of similar offenses. I will also point out that there are several Fidelity funds with good long-term performance, so this editorial is not an argument to avoid Fidelity’s mutual fund offerings. I’m merely using the fund giant as an example.

Turnover, however, is a factor you should consider when comparing one fund against another. Costs matter and reducing them is an easy way to increase your long-term performance. In the Top Funds Over Five Years article here, you’ll see expense ratios, turnover ratios and tax-cost ratios for all of the listed funds. This data is also included in our more comprehensive mutual fund guide, which was published in last month’s Journal.

Wishing you prosperity,

Charles Rotblut, CFA
Editor, AAII Journal
@CharlesRAAII