What is the Real Turnover of Pooled Index Funds?

Turnover rate in an investment fund refers to the percentage of a portfolio’s holdings that are replaced in a given year. While index funds are generally perceived as low-turnover investments due to their passive management, different types of index funds and even actively-managed ones vary significantly in turnover, which can have a substantial impact on both performance and an investor’s tax situation.

Typical Turnover Rates in Index Funds

1. S&P 500 Index Funds

S&P 500 index funds, which track the performance of the 500 largest publicly traded U.S. companies, are known for having relatively low turnover rates. On average, turnover for these funds tends to range between 2% and 5% annually. This number can increase in volatile markets due to small investor herding impacts. Small investor herding impacts occur when investors sell in fear during down-markets or buy during rallies because they’re worried about missing out. Turnover can also increase when companies are removed from the index. The frequency of these removals can vary depending on the health of the economy and the companies within the index. This low turnover is due to the passive nature of the strategy, where changes only occur when companies are added to or removed from the index, which happens infrequently.

For example, the Vanguard S&P 500 ETF (VOO) has an annual turnover rate of about 3.4% (per issuer fact sheet), while the SPDR S&P 500 ETF (SPY) has a turnover rate of around 3% (per issuer fact sheet). These low rates are characteristic of large-cap index funds, where changes in the index constituents are minimal.

The S&P 500 Index (SPX) itself typically has a very low annual turnover rate, generally ranging between 2% and 5%. This reflects the relatively infrequent changes in the index, which are largely due to company mergers, acquisitions, bankruptcies, or significant changes in market capitalization. The turnover rate primarily stems from the annual reconstitution of the index, where companies are added or removed based on changes in their market cap, financial performance, or eligibility.

Key Factors Contributing to Turnover in the S&P 500:

• Annual Reconstitution: The S&P 500 undergoes periodic reviews (quarterly, with a more significant annual reconstitution) by the S&P Dow Jones Indices Committee to ensure that the index remains representative of the U.S. large-cap market. Only a handful of companies are typically added or removed each year, contributing to the low turnover rate.

  For example, in 2023, only a few companies were replaced, such as Keurig Dr Pepper being added to the index, while Under Armour was removed. Such changes lead to small adjustments in the portfolio.

• Corporate Actions: Mergers, acquisitions, and spinoffs can also lead to changes in the index. If a company in the S&P 500 is acquired by another company, or if it splits into multiple entities, this triggers a change in the index composition. However, these events are relatively rare and have a minimal impact on the overall turnover rate.
• Market Capitalization Shifts: If a company’s market cap falls significantly or grows beyond the scope of the large-cap category, it might be replaced by a more suitable candidate from the mid-cap range, or vice versa. These changes, while more frequent than mergers or acquisitions, still contribute modestly to turnover.

Impact of Reconstitutions on Turnover

• Reconstitution Events: The annual reconstitution, which typically takes place around June each year, is the most significant event that impacts turnover. However, given that the index is designed to track large, stable companies, changes tend to be minimal. A turnover of about 4-5% is common during years with significant economic shifts or corporate restructuring, but in calmer periods, the rate may be closer to 2%.

Even with annual reconstitutions, the S&P 500’s turnover remains one of the lowest among index benchmarks due to the size and stability of the companies it tracks.

2. Small-Cap Index Funds

Small-cap index funds, which track smaller, more volatile companies, typically have higher turnover rates compared to large-cap funds. The annual turnover for small-cap index funds can range between 15% and 30%. For instance, the Vanguard Small-Cap Index Fund (VB) has a turnover rate of approximately 25%. This higher turnover occurs because small-cap companies are more prone to mergers, acquisitions, business failures, or fluctuations in market cap that result in more frequent adjustments to the index.

The Impact of Turnover on Fund Performance

Turnover directly affects fund performance by incurring trading costs such as commissions and bid-ask spreads. Even though index funds generally have lower turnover compared to actively managed funds, higher turnover can still erode returns over time.

For example, a small-cap index fund with a 30% turnover rate incurs more frequent trading costs than an S&P 500 fund with a 3% turnover. These trading costs, though often small, add up and reduce the overall performance of the fund. Lower-turnover funds avoid frequent buying and selling, which helps keep expense ratios down, translating into better long-term performance for investors.

Additionally, higher turnover increases the likelihood of the fund realizing capital gains, which can be distributed to shareholders and lead to taxable events. This can be particularly detrimental in taxable accounts, where investors may have to pay taxes on capital gains even if they haven’t sold their shares.

The Tax Impact of Turnover

Turnover has significant tax implications, particularly in non-tax-advantaged accounts. Funds with high turnover may distribute more short-term capital gains, which are taxed at higher ordinary income tax rates. In contrast, long-term capital gains, realized from assets held for over a year, are taxed at lower rates.

For example, an S&P 500 index fund with a 3% turnover is less likely to realize short-term gains compared to a small-cap index fund with a 25% turnover, meaning investors in the latter may face higher tax liabilities. The more frequently a fund buys and sells assets, the more short-term capital gains it generates, which can increase an investor’s annual tax bill.

For tax-sensitive investors, low-turnover index funds are typically more advantageous, as they defer capital gains taxes and allow more of the investment returns to grow tax-free within the fund until the shares are sold. This makes funds like the Vanguard Total Stock Market Index Fund (VTSAX), with a turnover rate of just 4%, particularly appealing for long-term, tax-conscious investors.

Although historical turnover in index funds may seem low, the tax impacts can be painful. This is especially true when the cost basis of companies in the fund is low. Investors that just bought-in could end up owing taxes, even if the overall value of the fund is down. This can also happen when large groups of small investors sell during down-markets, passing the tax impacts of the sells to all the investors in the fund.

Actively Managed Index Funds and Turnover

While most traditional index funds have low turnover, actively-managed index funds blur the line between passive and active investing, and typically have higher turnover rates. These funds aim to outperform the index by making tactical adjustments to the portfolio. As a result, turnover rates for actively managed index funds can range anywhere from 50% to over 100% annually, similar to actively managed mutual funds.

For example, the ARK Innovation ETF (ARKK), which is actively managed but still tracks themes, has a turnover rate of over 70%. This higher turnover results in more frequent trading costs and the potential for greater tax liabilities, reducing the after-tax returns for investors. Active strategies are generally less tax-efficient due to the constant rebalancing and shorter holding periods.

Do Index Funds Deliberately Hide Turnover Metrics?

Some index funds may attempt to obscure their turnover rates by focusing on other metrics, such as their expense ratios or historical returns. While the SEC mandates that funds disclose turnover rates, this information may not be prominently featured in advertising or marketing materials. Investors need to dig into the fund’s prospectus or reports to find the true turnover rate.

For instance, some funds that market themselves as low-cost may have higher turnover rates than expected, which could erode the cost advantage. Investors should be wary of funds that emphasize low expense ratios but don’t readily disclose turnover rates, as higher turnover can lead to hidden costs in terms of both performance and taxes.

Do Investors Care About Turnover?

Many investors, particularly retail investors, are often unaware of turnover rates or do not fully appreciate their significance. They may focus on headline metrics like historical returns and expense ratios without considering how turnover impacts their investment’s long-term performance and tax situation. This lack of awareness can lead investors to underestimate the drag that high turnover places on their portfolios.

More sophisticated investors, however, pay close attention to turnover rates, especially when investing in taxable accounts. For example, tax-efficient funds like the Vanguard Tax-Managed Capital Appreciation Fund (VTCLX) specifically aim to minimize turnover, thus reducing the likelihood of capital gains distributions.

Is Low Turnover Always Better?

While low turnover is often associated with better tax efficiency and lower trading costs, it’s not always the best metric for every investor. For example, some actively managed funds with higher turnover may outperform due to strategic stock selection, even after accounting for the associated costs.

That said, for long-term investors, especially those in taxable accounts, low-turnover index funds tend to offer better after-tax returns. Funds like Vanguard’s Total Bond Market Index Fund (VBTLX) or iShares Core S&P 500 ETF (IVV), with minimal turnover, are generally considered tax-efficient options that prioritize long-term, low-cost investing.

Conclusion

Turnover rates play a crucial role in determining an index fund’s performance and tax efficiency. While large-cap funds like the S&P 500 have low turnover, small-cap and actively-managed index funds tend to have higher turnover rates, leading to increased trading costs and tax liabilities. Investors, especially those in taxable accounts, should prioritize funds with lower turnover to maximize after-tax returns. However, understanding a fund’s strategy and objectives is key, as actively-managed funds may justify higher turnover with potential outperformance. In the end, turnover is a vital but often overlooked metric that investors should consider when selecting the right fund for their portfolios.