What is Portfolio Turnover Ratio? How to use it while investing in Mutual Funds?

Let’s say you have two friends; Sudha buys and sells stocks frequently while Shikha holds her investments with negligible changes in her portfolio. Sudha’s investment portfolio will see frequent changes while Shikha’s will remain much the same over time. In other words, Sudha has a high portfolio turnover.

About portfolio turnover

Just like Sudha and Shikha, some mutual funds frequently churn their portfolio while others keep their portfolio mostly unchanged. Mutual funds that frequently churn their portfolio have a high portfolio turnover (just like Sudha).

Computing portfolio turnover

A fund’s portfolio turnover ratio indicates the frequency with which changes are made in the fund’s portfolio. This is usually disclosed for the last one year.

Portfolio turnover is calculated by taking the lower of the total of new stocks purchased or sold over 12 months, divided by the fund’s average assets under management (AUM).

For example, let’s say ABC Fund bought stocks worth Rs 800 crore and sold stocks worth Rs 900 crore over the last year; the minimum of stocks bought/sold is Rs 800 crore.

Let’s say the average AUM of this fund is Rs 1,600 crore.

The portfolio turnover = 800 crore / 1,600 crore x 100 (i.e. 50%).

Implications of portfolio turnover

A high portfolio turnover implies that the fund is churning the portfolio frequently; this results in high transaction costs (this is because every buy/sell trade in a stock involves a transaction cost), which are charged to the fund and, in turn, may affect returns. A high portfolio turnover implies that the fund manager is looking to book profits and enter stocks at lower prices. A low portfolio turnover ratio indicates the fund manager’s strong conviction about his stock picks; this is a ‘buy and hold’ strategy. It also results in lower costs.

However, one cannot state that a low portfolio turnover is better than a high portfolio turnover. Often, if there is a rally in the markets, fund managers may need to transact to benefit from the rally, thereby resulting in a high portfolio turnover ratio. In other words, the portfolio turnover is determined by a combination of the fund management style and market conditions.

What is important is to judge whether a fund with a high portfolio turnover ratio has offered high risk-adjusted returns (risk-adjusted returns imply that the returns should be sufficient when compared to the amount of risk taken); only then can the portfolio turnover be warranted. If the fund has offered moderate or low returns despite high portfolio churn, the fund manager may be struggling with performance.

Note: You must compare portfolio turnover ratios of comparable funds; for example, you can compare portfolio turnover ratios of two equity diversified funds; however, you cannot compare portfolio turnover ratios of an equity diversified fund against that of a sector fund.

When not to use the portfolio turnover ratio

The portfolio turnover ratio should not be used for debt funds, index funds or arbitrage funds. In the case of debt funds, the fund manager’s focus is interest rates. When rates move up or down, the fund manager will trade in debt securities; however, the portfolio will remain broadly unchanged when interest rates are stable. Also, transaction costs are minimal in the fixed income market. In the case of index funds, the fund manager merely invests in stocks forming the index that is tracked. The amount invested in a particular stock depends on the weight the stock has in the index tracked. There is no change in the portfolio unless there is a change in the index. In the case of arbitrage funds, which use derivatives to hedge, again the portfolio turnover ratio is irrelevant as most highly traded and liquid derivative instruments have an expiry period of not more than three months, thus requiring regular churn.

The portfolio turnover ratio is one angle for assessing a fund manager’s performance. This must be used along with other relevant indicators such as performance versus the benchmark index and competing funds, risk-adjusted returns and consistency of good performance.

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Key Takeaways

  • A fund’s portfolio turnover ratio indicates the frequency with which changes were made in the fund’s portfolio over the last one year.
  • A high portfolio turnover is justified by considered better risk-adjusted returns.
  • While a low portfolio turnover ratio is good, a high portfolio turnover is not necessarily bad.
  • Compare the portfolio turnover ratio of comparable funds.