Portfolio Turnover Ratio in Mutual Fund Investing

Here’s what to look for in a Portfolio Turnover Ratio while investing in mutual funds:

Portfolio Turnover Ratio: Here's what to look for

Is your fund manager following a passive or a dynamic investing strategy?

You might wonder, “How does that matter to you?”

My friend, it might affect your fund returns! You need to be aware of it.

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Portfolio Turnover Ratio (PTR) comes handy to ascertain the investment moves of a fund manager. It reflects the psyche about the fund manager about the present and future state of capital markets and economic environment in general.

Portfolio Turnover Ratio shows his approach towards securities selection and portfolio construction. It demonstrates his skill in overall portfolio management as per the investment objective of the fund.

Simply put, Portfolio Turnover Ratio refers to the number of times the assets of the fund have been turned over. Conversely, it highlights the percentage of fund’s portfolio holdings that have been altered over the preceding one year.

Portfolio turnover ratio is simple to calculate.

It is the result of the total value of stocks purchased or the amount of securities sold (whichever is lower) over a particular period, divided by the total Net Asset Value (NAV) of the fund.

The period considered to measure PTR is usually a period of 12 months. Given below is the mathematical representation of the PTR calculation:

Portfolio Turnover Ratio = Lower of value of stocks bought or sold/Net Asset Value 

You can conveniently locate PTR in the factsheet of a mutual fund. It will be shown as a percentage.

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Portfolio Turnover Ratio & Fund Mutual Funds: A strategic approach

PTR can prove to be a useful tool in taking an informed fund selection decision. In addition to other financial ratios, you may use PTR for comparing two mutual fund schemes.

It radically widens and strengthens your overall understanding of where your mutual fund scheme is heading.

A PTR of 50% indicates that only half of the securities have been changed in one year. Conversely, a PTR of 100% signifies that the entire portfolio holdings have been changed within 12 months.

The level of PTR can be the result of fund manager’s investment strategy.

Also read: Goal-based investing through mutual funds

A low portfolio turnover ratio indicates a buy and holds strategy. It means that there’s little trading activity going on in that fund. The fund manager doesn’t find churning the portfolio quite lucrative. Hence, he sits tight.

There can be reasons for a low PTR. When the economy isn’t presenting enough opportunities like during a recessionary phase, the fund manager would prefer staying still.

In another scenario, he has a full conviction on his selected holdings for the entire investment horizon. Hence, he doesn’t feel the need to change the holdings.

A high portfolio turnover ratio, conversely, indicates a dynamic strategy. It means that there’s a high trading activity going on in that fund. The fund manager finds churning the portfolio very lucrative. Hence, he is actively managing the fund.

High PTR can occur due to varied reasons. When the economy is full of opportunities like during a rallying market, fund manager performs aggressive buying and selling.

In another scenario, he lacks conviction on his selected holdings for the entire investment horizon. Hence, he keeps changing the portfolio holdings now and then.

Levels of PTR also depend on a mutual fund’s underlying manner of asset allocation.

A passively managed fund like Index Fund has a low PTR than an actively managed fund like an arbitrage fund.

In this, the fund manager’s individual strategy has a lesser role to play. While fund’s overall strategy determines the PTR.

An index fund merly needs to emulate the underlying benchmark’s holdings. Hence, it doesn’t need frequent buying or selling of securities and has a low PTR.

Conversely, an arbitrage fund always seeks for price differentials to earn a risk-free return. Thus, it has to go through a lot of buying and selling of stocks.

In yet another scenario, new mutual fund scheme has a higher PTR than a scheme having a long history. It’s because the new scheme has just begun utilizing its potential requiring extensive trading.

However, the already established scheme has experienced market cycles. It knows what exactly it’s looking for and doesn’t require too much experimental trading.

The sudden change of fund manager may cause a temporary hike in the PTR; which would normalize eventually.

Portfolio Turnover Ratio: The Cost-benefit analysis

Each time a stock is bought or sold, it entails a brokerage cost. High levels of trading would cause the fund to incur substantial brokerage expenses.

A fund having high PTR thus indicates a costly investment strategy being followed by the fund manager. Compared to this, a low PTR means a cheaper strategy being pursued by the fund manager.

The levels of PTR would have a marked impact on your level of fund returns. Ultimately, every expense that the fund incurs creates a charge on the assets under management.

You may perceive it as a burden falling on your shoulders as an investor.

Standalone high PTR conveys lesser meaning. It needs to be compared with the fund returns to justify its presence.

The table given below shows the impact of PTR on large-cap equity fund returns:

Portfolio Turnover Ratio: Here's what to look for

ICICI Pru Value Discovery Fund has generated the highest returns in 5 year and 10 year intervals except in the 3-year interval. However, it has the highest PTR amongst all the other equity funds.

High PTR translates into a high risk-taking by the fund manager. Hence, the fund needs to generate higher returns commensurate with such risky behavior.

If on the other hand, you find a continuous erosion of returns, it points to an unfavorable situation. It means that the fund manager was clueless about the direction of the markets. Moreover, to correct a series of wrong bets, he got into aggressive trading.

Such an uncertain behavior can be detrimental to the health of your portfolio.

The context of PTR is more relevant for funds that are composed of equity as one its constituents. The higher the ratio of equity in a fund, the higher is the impact of PTR on returns.

Even though debt funds also have a PTR, it doesn’t eat into fund returns as it does for an equity fund or a balanced fund. It’s because debt funds don’t involve a brokerage cost like equity funds.

Once you have got into a mutual fund, you need to be vigilant about its whereabouts. If your fund is showing consistently high PTR without commensurate returns, it’s time to take a call. It would be better to switch to another competitive fund rather than to lose money.

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Final Words

Portfolio Turnover Ratio is an intelligent way to track the performance of your mutual fund portfolio. To derive a meaningful picture, keep your investment objective and risk appetite as a reference point.

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