Portfolio Turnover

B is correct. Fund B's 15% turnover rate means it holds positions much longer, generating primarily long-term capital gains taxed at preferential rates (0%-20% depending on income). Fund A's 150% turnover generates substantial short-term capital gains taxed as ordinary income at Sarah's 35% rate. Combined with Fund B's lower expense ratio (0.50% vs 0.90%), Fund B will likely deliver significantly better after-tax returns despite identical pre-tax performance.

A is incorrect because higher turnover doesn't indicate management quality and creates tax inefficiency for taxable accounts. High turnover generates more short-term gains taxed at ordinary rates, reducing after-tax returns. C is incorrect because turnover directly impacts after-tax returns through the timing and character of capital gains distributions (short-term vs long-term). D is incorrect because mutual funds absolutely generate capital gains distributions when they sell securities at a profit, and shareholders must pay taxes on these distributions even if reinvested.

C is correct. A 100% portfolio turnover rate means the fund bought and sold securities equal to 100% of its average portfolio value during the year, effectively replacing the entire portfolio once. This is calculated as the lesser of total purchases or total sales divided by average net assets.

A is incorrect because turnover measures the dollar value of trading activity relative to portfolio size, not the number of individual trades. A fund could make 10 large trades or 1,000 small trades and have the same turnover rate. B is incorrect because turnover is about trading activity, not fees. Fees are measured by expense ratio, which is typically 0.50%-1.50% for most mutual funds. D is incorrect because turnover measures trading frequency, not investment returns or portfolio value changes.

A is correct. Portfolio turnover is calculated as the LESSER of total purchases or total sales divided by average net assets. In this case: Lesser of $300M (purchases) or $400M (sales) = $300M. Then: $300M ÷ $500M = 0.60 = 60% turnover.

B (70%) makes a calculation error, possibly averaging the purchases and sales: ($300M + $400M) ÷ 2 = $350M, then $350M ÷ $500M = 70%. This is incorrect; you must use the LESSER value, not the average. C (80%) incorrectly uses only the sales figure: $400M ÷ $500M = 80%. The formula requires the lesser of purchases or sales, not just sales. D (140%) incorrectly adds purchases and sales: ($300M + $400M) ÷ $500M = $700M ÷ $500M = 140%. This would be double-counting; turnover uses the lesser of the two figures.

C is correct (the EXCEPT answer). High portfolio turnover does NOT lead to lower expense ratios. In fact, frequent trading increases transaction costs (commissions, bid-ask spreads, market impact costs) which reduce fund returns. While these trading costs are not included in the expense ratio itself, they still reduce net performance. High turnover does not create economies of scale that would lower expenses.

A is accurate: high turnover generates substantial transaction costs from brokerage commissions and the bid-ask spread on each trade. These costs reduce net returns even though they're not included in the expense ratio. B is accurate: frequent trading means securities are held for less than one year, generating short-term capital gains taxed at ordinary income rates (up to 37%) rather than preferential long-term rates (0%-20%). D is accurate: high turnover reduces tax efficiency by generating more frequent taxable distributions and a higher proportion of short-term (vs long-term) capital gains, increasing the investor's tax burden.

B is correct. Statements 1, 3, and 4 are accurate.

Statement 1 is TRUE: Fund X's 5% turnover means it rarely sells holdings, resulting in minimal capital gains distributions. Most gains remain unrealized until the investor sells shares. This is highly tax-efficient for taxable accounts. Fund Y's 80% turnover will generate substantial annual capital gains distributions that create taxable events.

Statement 2 is FALSE: Both funds track the same index (S&P 500), so they should have nearly identical returns before expenses. Higher turnover does NOT indicate better performance; in fact, it typically reduces performance due to transaction costs. If both track the same index, turnover differences reflect implementation inefficiency, not superior returns.

Statement 3 is TRUE: With identical pre-tax performance (both track S&P 500), the fund with the lower expense ratio (0.04% vs 0.75%) will deliver higher net returns. The 0.71% annual expense difference compounds significantly over time, making Fund X substantially better for long-term investors.

Statement 4 is TRUE: Fund Y's 80% turnover is far higher than typical for index funds (usually 5%-25%). This suggests more active trading and portfolio adjustments, potentially from frequent rebalancing or less efficient index tracking methodology. Fund X's 5% turnover is characteristic of pure passive index management.