Question

Suppose that every time a fund manager trades stock, transaction costs such as commissions and bid–ask spreads amount to .4% of the value of the trade. If the portfolio turnover rate is 50%, by how much is the total return of the portfolio reduced by trading costs?

Short answer

0.4%.

Step-by-step solution

Definition

Turnover rate also called turnover ratio is the amount of asset or liability that a company aggregates or replaces in relation to its sales.

Calculation of total return

Since the turnover rate is 50%, on an average, 50% of the portfolio is sold and replaced with other securities each year.

Trading costs on the sell orders are 0.4%;

Buy orders to replace those securities costs another 0.4% in trading costs.

Total trading costs will reduce portfolio returns by:

2 x 0.4% x 0.50 = 0.4%.