Portfolio Turnover ratio in Mutual funds – How Important is it?

Among the other parameters, portfolio turnover ratio is also one to look at while selecting a mutual fund scheme. This ratio tells the strategy the fund management is following as well as the conviction of the fund manager in the designed portfolio.

But here again one has to know that the portfolio turnover ratio cannot be used in isolation. There may be a reason for High or Low Portfolio turnover, so it has always to be seen in conjunction with the other ratios and performance evaluation.

This article is about The What, Why and How of the Portfolio Turnover ratio, plus how to interpret and use it while selecting a Mutual fund scheme.

What is the Portfolio Turnover Ratio?

As the name suggests, it is the turnover ratio in a portfolio. In other words, it tells how much the portfolio churning happened last 1 year.

Say for e.g. X and Y both runs a Portfolio. X has a tendency to trade in a portfolio and do continuous buy and sell in this, whereas Y follows a strategy of buy and Hold. So, in this case, X’s Portfolio has a higher Turnover ratio and Y has low.

Please note that nowhere the ratio is saying which strategy is better. It is just showing the kind of strategy the Investment manager is following.

The same way the Fund managers has different strategies in a different mutual fund structure. Some believe in high active management and some prefer buying and holding.

Computation of Portfolio Turnover ratio in Mutual fund scheme

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).

Say for e.g. In the last 1 year, if the Fund has purchased the stocks valuing Rs 1000 crore and sold stocks of 900 crores, and assuming the average AUM of Rs 1500 crore. Then the Portfolio Turnover will be calculated as follows:

Lower of Stocks Bought or Sold / Average AUM = 900/1500 = 60%

What impacts Portfolio Turnover ratio in a mutual fund?

The calculation above tells that the ratio is calculated on the basis of the volume bought or sold, but it does not tell the Reasons of the Buying and Selling of stocks in a Portfolio. It may be because of the fund’s strategy but the reasons could also be different. As in

Volatile Markets, which sometimes results in patient fund manager to react and book profits or an aggressive fund manager to stay calm and wait for the right time to enter.

Or it may also be because of the High flows (inflow/Outflow) in the scheme, which in turn results into frequent buying and selling in the scheme.

But since portfolio turnover ratio is calculated on the past 1-year data so it is viewed as if the extreme cases as discussed above have already been averaged out, and majorly it shows only the fund management way of investing only.

How to Interpret the Portfolio Turnover ratio?

What is good – Low Portfolio Turnover or High portfolio turnover?

High Portfolio turnover ratio means the portfolio is being churned frequently and which in turn also means high transaction cost. Whereas Low portfolio turnover results in less transaction cost.

But since the overall cost has been capped by the regulator in the form of the Total expense ratio, so what is important to understand is if the High turnover or High cost is resulting into some benefit in high risk-adjusted returns or not.

High risk-adjusted returns can only justify High portfolio turnover, else it clearly shows that the fund manager is struggling with the performance.

Sharpe ratio is a good measure to check the Risk-adjusted returns of the fund

Also, it is equally important to only compare the funds within the same category.

Below is the list of large-cap funds with their respective Portfolio Turnover ratio and Sharpe ratio numbers.

Source: Valueresearchonline Date:29.01.2019

As you can clearly see in the table above that even if DSPBR Top 100 has low PTR, but it also has lower Sharpe ratio too, On the other side, Axis Bluechip and ICICI Bluechip is showing the turnover ratio of more than 100%, but alongside they are also showing the Higher Risk-adjusted Returns. (In general higher the Sharpe ratio the better risk-adjusted returns the fund is generating)

Now, please note that I am nowhere suggesting you these funds as there are many other parameters to select a fund and portfolio turnover ratio is only one of those.

This is only for your understanding of the Term

It is also important to understand the category of the fund and how it works before looking at the portfolio turnover ratio.

Large and Midcap fund is expected to have lesser portfolio turnover as compared to Mid and Small cap funds. Balanced funds are supposed to have lower portfolio turnover than Balanced Advantage funds.

This ratio does not reflect anything in case of Index funds, Arbitrage funds, and Debt funds. Only actively managed equity funds should be compared to Portfolio Turnover ratio

Conclusion:

Portfolio turnover ratio is generally used to gauge the fund manager’s style of investing as in how much churning is happening in the portfolio. The high turnover ratio may not be that bad if it is resulting in high risk-adjusted returns.

But to select funds only on the basis of portfolio Turnover may not be wise since there are lot many other factors needs to be considered for this.