Monday, Sep 25, 2023

Understanding Portfolio Turnover Ratio: How It Affects Fund Performance

Outlook Money

Understanding Portfolio Turnover Ratio: How It Affects Fund Performance

The portfolio turnover ratio is a key metric in evaluating mutual funds and understanding a fund manager’s strategy. Read on to know its impact on fund performance

In mutual funds, the portfolio turnover ratio measures the rate at which a fund’s securities are bought and sold within a year.  

Aggressively managed funds tend to have higher turnover rates as compared to conservative funds. High turnover rates can lead to increased expenses in terms of fund management.

The portfolio turnover ratio is calculated by dividing the minimum of total value of stocks purchased or sold over one year by the fund’s average assets under management (AUM).  

For instance, if a fund sold stocks worth Rs. 1,000 crore and purchased stocks worth Rs. 1,400 crore in a year, with an average AUM of Rs. 12,000 crore, the turnover ratio would be 1,000/12,000*1,000 equalling 8 per cent.

Implication On Returns

Understanding the turnover ratio is crucial for investors, as it has implications for fund returns. Higher turnover results in increased brokerage costs, which can reduce the overall returns for investors. Therefore, a high turnover ratio without a significant outperformance compared to the benchmark is counterproductive.

Funds with lower AUM provide fund managers with more freedom to churn the portfolio. If this active trading strategy leads to good performance, the fund’s popularity may grow, resulting in a decrease in turnover over time.

Is There An Ideal Portfolio Ratio?

Turnover ratios hold most relevance in case of actively managed equity-oriented schemes. Except for arbitrage funds, a high turnover ratio, above 100 for instance, can indicate a lack of conviction in the fund manager’s investment strategy, but this should not be a universal guiding principle.

There are other factors to consider, too, such as the fund’s age, where aggressive churning may be employed to fuel growth or outperform the market during volatile times.  

Investors should be concerned about a high turnover ratio only when it is not accompanied by sufficient returns.

In the analysis of 55 large-cap and mid-cap funds, the average turnover ratio is around 57.3422. Roughly half of the funds have turnover ratios above the average, while the other half have ratios below it. The Quant Large Cap Fund (G)-Direct Plan stands out with the highest turnover ratio of 175, while the HDFC Large and Mid Cap Fund (G)-Direct Plan has the lowest ratio at 3.0300.

A low turnover rate indicates a buy-and-hold strategy by the fund manager. It perhaps indicates that they have strong conviction in their investment strategy.

Although high turnover does not guarantee above-average returns, it can be expected that returns can be above average because the fund house has to compensate for costs associated with frequent trading, such as brokerage fees.  

A debt fund’s portfolio only churns a little depending on inflation and interest rates, because when interest rates are steady, the ratio remains relatively stable.

Ideally, an index fund’s turnover ratio should align with that of the index it tracks. Passively-managed funds, such as exchange-traded funds (ETFs), typically have low turnover ratios.

To obtain the portfolio turnover ratio for a specific scheme, refer to its factsheet. However the portfolio turnover ratio should not be the sole basis for investment decisions. Your investment goals, risk tolerance, fund performance and AMC performance are also of much relevance.


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