Portfolio Turnover Ratio

Portfolio Turnover Ratio is important for analysing the performance of a mutual fund. It provides a peek into the trading activity in a mutual fund in a given period of time. In addition, it reveals the fund manager’s performance. However, before establishing the importance of the portfolio turnover ratio in mutual funds, investors must learn about its different aspects.

In this article, we will try to understand what is portfolio turnover ratio and how it can help you in your investment journey.

What is Portfolio Turnover Ratio?

The Portfolio Turnover Ratio (PTR) is the frequency at which the assets held under a fund are changed over the years. In simple words, PTR tells you the number of times the fund manager bought or sold assets under a fund over a given period of time. PTR is often determined by the market conditions and fund management style.

How to calculate Portfolio Turnover Ratio?

Calculating the portfolio turnover ratio in mutual funds is a very simple exercise. You can take the minimum of either the stocks bought or the stocks sold under a fund and divide the figure by the average assets under management (AUM). The resultant number is the portfolio turnover ratio of that particular fund. The stocks and the AUM have to be taken from the same time horizon. The time horizon can be monthly or yearly. The PTR is always stated in percentage.

Suppose an equity fund purchased stocks worth Rs 375 crore and sold stocks worth Rs 450 crore. The average AUM of the fund is Rs 1,500 crore. In this case, the portfolio turnover ratio of the fund is 25%, which means one-fourth of the stocks were traded. 

This can be calculated using the following formula:

What does a high Portfolio Turnover Ratio indicate?

The portfolio turnover ratio in mutual funds is a helpful indicator of the fund’s activities. High and low PTRs can indicate the following:

• Frequent churning: A high portfolio turnover ratio indicates a high frequency of churning of the stocks. It means the stocks in a fund were bought and sold many times. A 100% portfolio turnover ratio thus implies fully churned stocks.
• Higher cost: A high PTR requires high transaction costs, making fund management expensive. Trades are done based on research and analysis, which can require capital as well. Many traders charge transaction fees as per their preference. This added cost has a direct impact on the returns.
• Market conditions: Market conditions often influence the fund management style. A stable market will allow the fund managers to take risks by selling and purchasing the stocks. Funds with dynamic asset allocation may have high PTR as well.

What does a low Portfolio Turnover Ratio indicate?

The fund management style, market conditions and other indications of a low portfolio ratio are the exact opposite of high portfolio turnover. A low portfolio turnover ratio indicates the following:

• Low churning: A low portfolio turnover ratio indicates low trading activity. The stocks are seldom purchased and sold. They are held throughout their tenure to assure higher returns.
• Low cost: Less trading activity makes fund management less expensive. Consequently, the transaction cost is lower and therefore, the returns are not much affected by the management cost.
• Fund manager’s performance: The management strategy followed in this fund is generally a ‘buy and hold’ style. The fund managers are confident in the purchased stocks and want to hold them till the tenure horizon.
• Market conditions: The market, leading to a low portfolio turnover ratio, is generally volatile. The high risk factors make fund managers less active.

Taxes and PTR

The more a fund manager purchases or sells stocks, the higher the expense ratio becomes. Higher tax is a result of capital gains distribution. These taxes impact everything from the fund manager’s trading costs to the investor’s returns. So, a fund with a high portfolio ratio will generate higher taxes than a fund with a low portfolio turnover ratio.

How to Use Portfolio Turnover Ratio to Evaluate Mutual Funds?

Understanding the portfolio turnover ratio is crucial as it can help evaluate mutual funds by measuring the risk factors. By comparing the PTR of two or more mutual funds, an investor can find the most suitable options.

The aggressive strategy of fund managers leads to a high expense ratio; however, the high expense ratio is adjusted by a high return rate. As said earlier, the fund managers can keep purchasing and selling the stock just to meet the ideal return rate. However, the required high trade fees in this scenario affect the investor’s returns.

When a high return rate adjusts the higher expense ratio, the investors keep gaining capital. But investors are forced to face a loss in capital when the higher expense ratio is not accompanied by high returns. The investors thus end up paying higher fund management costs without getting adequate returns.

Investors tend to avoid investing in funds with a high portfolio turnover ratio due to the high expense ratio. But they miss out on the chances to get higher returns that could have been achieved by investing in superior funds with consistent performance.

The following are a few other aspects that need to be kept in mind:

• Index funds generally have a low turnover ratio, but they can provide higher returns
• Comparatively, smaller or newer funds tend to have higher PTR
• The PTR of funds with the Growth Investing strategy is higher than funds with the Value Investing strategy
• PTR is more appropriate for funds with equity exposure.

Investors must understand all the factors influencing the returns before investing. Ratios other than PTR should also be used while analysing the funds. More importantly, each investor has his/her own investment objective and risk profile. The PTR can help the investor choose the correct investment option by balancing his/her risk appetite with the fund’s risk level.