How important is the portfolio turnover rate of a fund?

Paul's Answer:

Every mutual fund has a turnover ratio, a measure of how much buying and selling goes on inside the fund. A ratio of 150 percent means a fund with $80 million of assets, to use a hypothetical example, sold $120 million worth of its investments in 12 months.

Some index funds have turnover ratios under 10 percent, while bond funds and some aggressive stock funds can have ratios over 500 percent.

In IRAs, 401(k)s and other tax-sheltered plans, there are no tax implications of trades in the fund.

But in taxable accounts, portfolio turnover affects taxes that shareholders must pay. The fund itself doesn't pay taxes on its capital gains and losses. Instead it passes them along to shareholders, usually once a year, in the form of capital gains distributions. The higher the portfolio turnover, the higher the potential tax bite.

A low turnover ratio is desirable from a tax standpoint, but some funds' investment strategies call for frequent trading, and the resulting tax consequences are simply part of the price a shareholder pays for owning that fund, and presumably for benefiting from its profitable trades.

Don't select or avoid funds based just on turnover ratios. But in a taxable account, when other things are equal, choose a fund with a lower turnover ratio.