Select MF: What is Portfolio Turnover Ratio and Why it is Important?

We are back with the next Select MF blog; and this time we are going to talk about Portfolio Turnover Ratio. The performance of all Equity Funds is driven by how the portfolio is constructed; and the entry and exits from stocks. The portfolio turnover ratio is one of the measures which indicates the fund managers’ investment style and conviction in the stocks he/she holds. Let’s understand this in detail and it’s the significance for mutual funds.

What is the Portfolio Turnover Ratio?

Every mutual fund manager buys and sells stocks regularly based on his view of future market performance. But, how will we know whether the fund manager changes the portfolio too frequently or does not change very often? The metric that can be used to measure this is the Portfolio Turnover Ratio.

Portfolio Turnover Ratio is an indicator of churning in the portfolio. In simple terms, it measures the frequency of buy and sell transactions in the mutual fund’s underlying portfolio. This ratio is indicated in % terms and is disclosed for the last one year.

Here’s how the portfolio turnover ratio is calculated :

Lower of total shares purchased or sold over last one year / Fund’s Average Asset Under Management

You can check this ratio on each fund’s factsheet that is released every month. Before we get into the significance and use of Portfolio Turnover Ratio;  let’s look at some equity funds with the lowest and highest turnover ratio:

We have only considered five Equity categories for the above data: Large Cap, Mid Cap, Small Cap, Large & Mid Cap, Multi Cap.

Why is the Portfolio Turnover Ratio important?

It is natural for a fund manager to buy and sell stocks in the portfolio. Based on the opportunity available in the market and to book profit in the portfolio, the fund managers churn the portfolio.  If the turnover ratio is 100% or more than that, then it means that the fund manager has completely churned the portfolio over the last year. Normally, a mutual fund with a higher turnover ratio has a higher cost associated with it.  Because every mutual fund incurs cost while carrying out buy and sell transactions. Similarly, funds with a lower turnover ratio incur lower costs.

But apart from costs, there is also another significance of the portfolio turnover ratio. Most of the fund managers who have high conviction in their holdings, tend to use the strategy of buy and hold. For such fund managers, the portfolio turnover ratio is usually lower. Whereas, fund managers with momentum strategy churn portfolio more frequently and have a higher turnover ratio.

On a standalone basis, you cannot use the Portfolio Turnover Ratio to select funds. But you can compare the turnover of two funds from the same category. For a higher turnover ratio, the performance should also be higher to justify the constant churning in the portfolio. Despite the high turnover, if the fund performance is below average then it is a sign that the fund manager is struggling with delivering good performance.

When you should not use the Portfolio Turnover Ratio?

For long term equity categories, a Portfolio Turnover Ratio is useful. However, you cannot use this metric for Debt Funds, Index Funds, and Arbitrage Funds. Here’s why. In the case of Debt funds, the fund manager takes a call on underlying securities based on the interest rate movement and credit quality. If the fund manager thinks that the credit quality of any paper is going to deteriorate, he/she may exit that particular paper. Similarly, based on the fund manager’s view on interest rate movement, the underlying portfolio may get changed. Hence, Portfolio Turnover Ratio is not relevant for debt funds.

Index funds are passively managed and are based on a particular index. When the underlying index constituents change, the index funds have to realign the portfolio.  Arbitrage funds invest in derivatives and extremely liquid instruments with short term maturity. With such structure, the turnover will naturally be very high for Arbitrage and hence irrelevant.

Portfolio Turnover Ratio is just one of the factors that will help you in selecting the right fund for your portfolio. We will be writing about such important factors every week to help you select the right fund.