Mutual Funds and Portfolio Turnover (pdf) — Investment Company.

averaging technique that

averaging technique that treats each fund equally in the calculation. Such an approach works well if the items being averaged—in this case the turnover rate of each stock fund—exhibit the stand ard textbook “bell-shaped” curve, with roughly an equal number of observations above and below the simple average, and with few observations that are very far from that average. Turnover rates of funds do not fit this pattern, however, and the simple average accordingly is not the most accurate depiction of a typical fund’s turnover. First, there are many more funds with turnover rates below the simple average than above. Nearly threequarters of all stock funds have a turnover rate below the simple average of 117 percent in 2004, and about half of all stock funds have a turnover rate of less than 60 percent in 2004 (Figure 1). The reason that most funds have a turnover rate below the simple average is that a small percentage of funds have turnover rates that are considerably higher than the simple average. Even though these funds with high turnover rates are a small percentage of all stock funds, there are more of these funds than what is assumed by the stand ard textbook bell-shaped curve, and the turnover rates of these funds cause the simple average to overstate the trading activity of most fund managers. For example, excluding the 200 funds with the highest annual turnover rates—about 4 percent of all stock funds—drops the simple average by more than 40 percentage points to 76 percent in 2004. 4 Many of the funds with the highest turnover rates trade frequently because they are designed expressly for investors who want to move in and out of the stock market quickly and frequently. These funds must regularly buy and sell securities to accommodate the purchase and redemption activity of their shareholders. The total assets of these funds tend to be small because they have fewer long-term investors than the typical stock fund. Both the higher transaction activity and lower levels of assets produce higher turnover rates for these funds. The managers of these funds often attempt to minimize transaction costs by using futures and options contracts. FIGURE 1 Cumulative Percent of Stock Funds by Annualized Portfolio Turnover Rate, 2004 (percent of funds) 75 82 87 63 47 24 0 30 60 90 120 150 180 Portfolio Turnover Rate (percent) Source: Morningstar Principia Pro Plus (June 2004) 4 The simple-average portfolio turnover rate for 2004 is computed from data in the Morningstar Principia Pro Plus, June 2004 database. The turnover rates for 2004 are stated at an annual rate to make them comparable to earlier years. Only one share class of each multiple share class fund is included in the computation of the average. Page 2