When a professional money manager designs an investment portfolio, a strategy is attached to the fund, and the manager buys and sells financial securities, such as stocks, accordingly. Economic and market conditions inevitably change, however, and the makeup of a fund at the beginning of the year may be much different by year's end. Portfolio managers of mutual funds, for instance, buy and sell stock securities according to strategies but also in response to external conditions. The pace and percentage at which a manager trades during a period of time is known as fund turnover.
There are countless reasons for fund turnover. For instance, if it is a mutual fund's strategy to invest solely in stocks with a small capitalization, that is companies worth a certain amount based on an equation, the manager will initially buy stocks that fit the criteria of that fund. Companies grow, and stock prices rise, and what was once a small capitalization stock may evolve into a mid-size or large capitalization investment. Subsequently, a fund manager may need to sell certain stocks in keeping with the strategy outlined by the fund.
Professional money managers may place price limits on stock investments. For instance, if the value of a stock reaches a certain high or drops to a designated low price, sell orders may automatically go into effect. This means that the fund manager has reaped the anticipated profits or has taken all of the risk that is allowed. As a result, the makeup of the portfolio changes, and fund turnover increases.
Historically, mutual funds with excessively high fund turnover have performed mixed. There are always exceptions, however, and some active managers, that is fund managers who buy and sell securities at will based on a fund's strategy, generate impressive returns with turnover percentages in the triple digits. Stagnant funds where there is little turnover might do well under the right circumstances. Changing market and economic conditions may be more conducive to high or low fund turnover, and subsequently, active fund managers must be nimble.
Passively managed funds are mutual funds that trade in comparison with a broader market index. Fund managers of passive portfolios do not make nearly as many trades as active managers, and as a result, the fund turnover tends to be much lower. A benefit to this style is that there are fewer transactions and potentially lower fees and taxes in a fund with less trading activity, which could serve as a financial perk to investors as long as profits are in line with expectations.