The portfolio turnover ratio is a metric that tells investors about the frequency with which managers buy and sell the assets in their mutual fund’s portfolio. It helps investors get a glimpse of the kind of investment strategy the fund follows and also has an impact on fund expenses and returns. In this article, we’ll cover the essential details about portfolio turnover in mutual funds every investor should know.
What is Portfolio Turnover?
A mutual fund’s portfolio contains a number of assets. Over a period, the professional managers handling these funds sell certain assets and purchase new ones based on factors like market conditions, investment objectives, and opportunities for better returns. This frequency with which managers rebalance their fund’s portfolio is measured by a metric called the portfolio turnover ratio. To say it simply, the portfolio turnover ratio or PTR is the rate at which fund managers buy and sell assets over a period of 12 months.
For example, a mutual fund with 30% annual portfolio turnover would suggest that the fund manager replaced 30% of the portfolio’s holdings during the year and that the remaining 70% of the assets were held. Similarly, a 100% annual portfolio turnover would mean that 100% of the fund’s assets were replaced over the course of the year.
The higher the PTR, the more actively or aggressively the fund is managed. On the other hand, a lower portfolio turnover implies that the fund is passively managed and the manager has decided to take the buy-and-hold approach.
Now that you have a basic idea of what is portfolio turnover ratio, let’s have a look at an example to understand how it is calculated.
How is Portfolio Turnover Calculated?
Portfolio turnover is stated as a percentage. Here’s the formula used in portfolio turnover ratio calculation:
Portfolio Turnover Ratio = The lower of the total buy or sell value / Average AUM
Here, AUM refers to assets under management, which is the total market value of the assets in the portfolio. Check out this example to understand the calculation:
Imagine that in 2024, Fund X had an average AUM of Rs. 5,000 crores. In the same year, assets worth Rs. 1000 crores were bought and Rs. 1200 crores worth of assets were sold.
PTR = Rs. 1000 crores (Lower value) / Rs. 5,000 crores
PTR = 20%
A point to remember about the portfolio turnover formula is that both the average AUM and the buy and sell values must belong to the same period, like a year or quarter.
Impact of Portfolio Turnover on Mutual Funds
The portfolio turnover ratio in mutual fund investments can give you some insights into a fund’s performance, fees, and investment styles. Here’s what high and low portfolio turnover ratios indicate about a mutual fund:
1. When a fund has a high PTR:
A high turnover ratio first and foremost suggests that the fund is actively managed. The higher the PTR, the more aggressively the manager bought and sold the assets within the portfolio over the year.
Secondly, every time a security is added or sold, a transaction cost is applied. This includes fees such as brokerage charges, research commissions, and taxes. When trading is frequently done, the total transaction costs also rise. This has a significant impact on the fund’s returns, as the expense ratio rises. This, however, does not mean that a high turnover ratio is a bad thing.
A big reason why managers buy and sell frequently is because they are on the lookout for profitable opportunities. If the fund manager’s aggressive strategy is successful at identifying and exploiting such opportunities in the market, a high turnover ratio can lead to higher returns. Sometimes, market conditions necessitate frequent buying and selling of assets to manage risk.
2. When a fund has a low PTR:
Lower turnover ratios indicate passive management. Such numbers can be seen in index funds and in those funds where the manager adopts a buy-and-hold strategy. In the latter case, managers hold on to assets through different market conditions as they believe they will overcome short-term volatility and perform well in the long run.
Trading is not done aggressively, which means lower expenses for investors.
Portfolio Turnover Ratio in Mutual Funds
The portfolio turnover in mutual funds should always be compared to other funds in the same category. This is because different categories of funds have different investment objectives and philosophies that result in varying levels of portfolio turnover.
For example, unmanaged funds like index funds have much lower turnover ratios compared to equity category funds like small-cap funds. The reason is simple – Index funds have much lower trading activity and thus incur minimal costs, whereas, in small-cap funds, managers quite frequently buy and sell securities to capture growth opportunities or manage risk. Similarly, value-focused funds generally have lower PTR compared to growth-focused funds.
When conducting your mutual fund research, you’ll often find that besides a particular fund’s PTR there is a category average provided. You can use this benchmark to compare a fund’s turnover to its competitors within the same category.
Advantages and Disadvantages of Portfolio Turnover
1. Advantages of High Portfolio Turnover Ratio:
Frequent buying and selling of assets can be beneficial under some circumstances. When managers have the flexibility to trade, they can target short-term opportunities and earn better returns potentially. These high returns offset the transactional costs and yield better results for investors.
Frequent trading can also help fund managers adapt quickly to changing market conditions. Not only do these conditions allow them to buy undervalued assets but also sell the overvalued stocks they are holding.
2. Disadvantages of High Portfolio Turnover Ratio:
High PTRs mean more expenses and taxes due to trading, which can dampen returns for investors. If the holding period of assets on average is low, then it could also mean that the manager is taking on higher risk by chasing market trends rather than focusing on the assets at hand. These bets can pay off, but they also carry the potential for losses.
Portfolio Turnover Ratio and Investment Strategies
How high or low a fund’s portfolio turnover ratio is can tell investors a lot about the style of management. For example, a fund with high turnover would suggest that the manager is adopting an aggressive investment strategy. As stated before, this does increase the transactional costs, however, fund managers make these trades as they believe the returns they can get with the churning would be much higher than the expenses incurred.
At the very least, they hope to make back these costs. High portfolio turnover indeed adds more risk but also increases the potential returns.
On the other side, a low turnover ratio could reveal that the fund is either passively managed or that the manager has taken a buy and hold stance. Such fund managers are confident in their bets and invest for the long term.
Examples of Portfolio Turnover
Portfolio turnover is calculated using the formula:
Portfolio Turnover Ratio = Lower of the total buy or sell value / Average AUM of the fund
The average AUM of a fund was 1000 crores in a particular year. During this period, the fund manager bought 600 crores worth of securities while selling Rs. 650 crores worth. The turnover ratio would be calculated using the 600 crore figure as it is the lower of the two.
Thus, PTR = 600/1000
PTR = 60%
This means that 60% of the portfolio’s holdings were replaced over the year.
Conclusion
Portfolio turnover ratio is a percentage that tells us about the frequency with which trading was conducted within a mutual fund’s portfolio over a period, such as a quarter or a year. If the fund manager bought and sold many assets, the turnover ratio in mutual fund would be higher compared to a passively managed fund’s PTR. A high turnover ratio is associated with higher costs but can also translate to better returns and offset the expenses incurred due to active trading.
PTR can vary across different fund types and investment styles, so there’s no ideal turnover ratio that everyone can use. Aggressive styles of management can lead to higher PTR and returns, and even buy-and-hold styles can lead to higher returns while keeping costs low.
Avoiding funds with high turnover ratios just to save some expenses can turn out to be a poor decision.
When looking at mutual funds, a number of factors should be considered like consistency of past returns, risk-adjusted returns, fund manager’s skill and track record, AMC’s reputation, and others. Also, investors should make sure their choices align with their financial goals and risk tolerance. A qualified financial advisor can help people assess these factors and pick suitable choices.
