Portfolio Turnover

Two domestic equity funds have posted nearly identical gross returns over five years. The Marchetti Index Fund reports annual portfolio turnover of 15 percent; the Marchetti Opportunity Fund reports 140 percent. A customer is choosing between them for a fully TAXABLE account. What should the representative point out?

1. A.The high turnover fund is likely to distribute more short-term gains taxed as ordinary income and to bear higher transaction costs, so its after-tax return is likely lowerCorrect. Equal gross returns do not mean equal after-tax returns when turnover differs sharply.
2. B.Turnover affects only the stated expense ratio, which already captures the differenceBrokerage commissions and spreads generated by trading are not included in the expense ratio.
3. C.Higher turnover means a higher dividend yield, which benefits the taxable investorTurnover measures trading activity, not the income the portfolio produces.
4. D.Turnover is irrelevant in a taxable account because all fund distributions are taxed identicallyShort-term gains are taxed as ordinary income while long-term gains receive preferential rates, so the mix matters.

Why: Portfolio turnover measures how much of the portfolio is replaced in a year. High turnover means the manager realizes gains frequently, and gains on positions held one year or less are short-term and are distributed to shareholders as ordinary income. High turnover also generates greater transaction costs, which come out of returns. So with equal gross returns, the high turnover fund is likely to deliver the lower after-tax return in a taxable account.

Two large-cap equity funds carry nearly identical expense ratios and have posted similar long-term PRETAX returns. The Ashcroft Fund reports a portfolio turnover ratio of 12%; the Delamere Fund reports 145%. Adviser Piotr Kaczmarek must choose one for a high-bracket client TAXABLE account. The most important practical difference is that the Delamere Fund is likely to:

1. A.Carry more interest rate risk, since portfolio turnover measures the average maturity of the fund holdings.Incorrect. Turnover measures trading activity, not maturity, and neither fund is a bond fund.
2. B.Report a lower expense ratio, because brokerage commissions are included in that ratio and get spread across a larger number of trades.Incorrect. Brokerage commissions are NOT included in the expense ratio; they are a separate drag on returns.
3. C.Distribute mostly LONG-term capital gains, because heavy turnover constantly refreshes the portfolio with new long-term positions.Incorrect. Rapid turnover produces short holding periods, and short holding periods produce short-term gains.
4. D.Incur substantially higher trading costs and distribute larger short-term capital gains, cutting the client after-tax return even though pretax returns look alike.Correct. High turnover means more commissions and spreads plus more short-term gain distributions taxed at ordinary rates.

Why: Portfolio turnover measures how much of the portfolio is replaced in a year. A 145% turnover implies an average holding period well under twelve months, which produces two costs the expense ratio never shows. First, brokerage commissions and bid-ask spreads on all that trading are paid out of fund assets but are excluded from the reported expense ratio. Second, gains realized on positions held a year or less are distributed to shareholders as SHORT-term capital gains, taxed at ordinary income rates. In a taxable account those two drags can erase an otherwise identical pretax record.