In equity investing, portfolio turnover is another name for portfolio trading. Passively managed portfolios have little or no turnover. Actively managed portfolios, by design, have turnover.
Turnover rate is a measure of portfolio turnover. It is calculated over a given period as the lesser of stock purchases or stock sales, divided by the portfolio’s average market value during the period:
[1]
Turnover rate is typically reported on an annual basis. By construction, [1] is intended to exclude stock purchases or sales arising from new investments in, or withdrawals from, the portfolio over the specified period.
Because trading generates transaction costs, turnover is a drag on a portfolio’s performance. Actively managed mutual funds typically have annual turnover rates between 75% and 125%. More aggressive funds, including equity hedge funds, may have annual turnover rates of several hundred percent.
The notions of portfolio turnover and turnover rate can be extended to portfolios holding instruments other than equities, but some shot-term instruments and cash-settled derivatives can be problematic. For example, a cash-settled forward will have no purchase or sale price to enter into formula [1]. As another example, a money market fund might purchase short-term cash instruments throughout the year, holding each until maturity. Because it never sells any of the instruments, its turnover rate as calculated by [1] is zero. But this belies the fact that the portfolio’s composition changes continually due to new purchases.