How do frequent trades in actively managed funds impact investors?

Question

BlackTom AI · Accepted Answer

When evaluating the impact of frequent trades in actively managed funds, one must consider the trade-offs between turnover, taxes, and after-tax performance.
Option 1: 'They create a more diversified portfolio' In reality, diversification is determined by the number and mix of holdings, not by the frequency of trades. High turnover does not inherently guarantee greater diversification and can even reduce it if trades concentrate assets in a narrower set of positions.
Option 2: 'They prevent access to bond markets' This statement is inaccurate. Frequent trading does not inherently prevent access to bond markets; investors can still hold or trade bonds. Turnover deals with how often holdings are bought and sold, not with access barriers to asset classes.
Option 3: 'They lead to higher tax inefficiencies and reduced returns' This is typically true for actively managed funds with high turnover. Short-term capital gains tax treatment on frequent trades can erode after-tax returns, and higher trading costs can further trim performance, leading to poorer net results for investors.
Option 4: 'They ensure consistently higher returns' High turnover does not guarantee higher returns; in fact, it often correlates with higher costs and tax drag, reducing overall performance. Consistent outperformance is not supported by simply trading frequently.
In summary, the most accurate statement about the impact of frequent trades in actively managed funds is that they contribute to tax inefficiencies and can reduce after-tax returns, while the other options misstate the effects of turnover or overlook the tax and cost implications.

FIN 408 001 WN 2025 FIN 408 - Final Exam

How do frequent trades in actively managed funds impact investors?

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