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The turnover ratio is a process of measuring the number of times that holdings are sold within a specified period of time. Generally, a turnover ratio is calculated to cover either a calendar year or a period encompassing twelve consecutive calendar months. The same formula may be used to evaluate shorter or longer periods of time.
A turnover ratio is usually associated with the activity of a mutual fund account. The main idea is to determine the percentage of assets that are sold or turned over within the period of time cited. While some amount of turnover ratio is expected with any group of mutual funds, investors generally look for funds that experience a relatively low percentage of turnover.
The easiest way to understand a turnover ratio is to evaluate the selling activity over the course of a calendar year. On 1 January of a given year, a given mutual fund has an inventory of 200 stocks. Over the course of the year, 150 of those stocks are sold and 150 different stocks are purchased. At the end of the year, the fund still contains the same number of stocks and on the surface appears healthy. However, the turnover ratio for the year stands at 75%.
When the turnover ratio for a mutual fund appears to be somewhat high, investors do well to investigate the reasons why the turnover was not lower. There are often legitimate reasons why the selling activity in the fund was higher than an acceptable level. This may include shifts in the economy or political situations that had a negative impact on the stocks that were ultimately sold. Thus, it is not proper to assume that a high turnover ratio automatically means the fund is unstable or is not managed properly.
As with many indicators, the calculation of a turnover ratio serves as a point of reference for the investor. A turnover ratio that is considered reasonable indicates an investment situation that is stable and worth consideration. At the same time, a mutual fund that carries a high turnover ratio for several consecutive periods should be investigated closely before investment takes place. While the reasons for the high activity of selling may be innocuous, an unusual amount of turnover may also indicate the presence of factors that would negatively impact the investor.