The term Portfolio Turnover Ratio is an important aspect of analysing the performance of a mutual fund. It gives an idea of the trading activity of any mutual fund in a given period of time. In addition, it reveals the fund manager’s performance. But before establishing the importance of Portfolio Turnover Ratio in mutual funds, investors must learn about its different aspects.
In this article
What is Portfolio Turnover Ratio?
Portfolio Turnover Ratio is the frequency in which the assets held under a fund has changed over the years. In simpler words, PTR provides a measurement on how many times the fund managers bought or sold the assets under a fund over a period of time. PTR is often determined by the market conditions and fund management style.
How to calculate Portfolio Turnover Ratio?
The portfolio turnover ratio can be calculated using a very simple method. You can take the minimum of either bought stock or sold stocks under a fund and divide them by the average Assets Under Management (AUM). The number you get 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.1500 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 Portfolio Turnover Ratio formula:
|Minimum stocks bought or sold (Rs.375 crore)) / Average AUM (Rs.1500 crore) = Portfolio Turnover Ratio (25%)|
What does High Portfolio Turnover Ratio indicate?
Portfolio Turnover ratio understanding in the fund’s activities. The high and low PTR can indicate the below-mentioned factors:
- Frequent churning: A high Portfolio Turnover Ratio indicates a high frequency in the churning of the stocks. It means the stocks under a fund were often bought and sold. A 100% portfolio turnover ratio thus implies an entirely churned stocks.
- Higher cost: A higher PTR requires a higher transaction cost, making the fund management expensive. Trades are done based on research and analysis, which can require capital as well. Many trades have their own transaction fees. This added cost in the fund managers has a direct impact on the returns.
- Market condition: 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 Low Portfolio Turnover Ratio indicate?
The fund management style, market condition and other indications of Low Portfolio Ratio is the exact opposite of High Portfolio Turnover.
- Low churning: A Low portfolio Turnover Ratio indicates low trading activity. The stocks are seldom purchased and sold. They are kept intact during their tenure to assure higher returns.
- Lower cost: Less trading activities make fund management less expensive. There is less transaction cost and therefore, the return doesn’t get much affected by the management cost.
- Fund Manager’s Performance: The management strategy followed in this fund is generally ‘buy and hold style’. The fund managers are confident on the purchased stocks and want to hold them till the tenure horizon.
- Market condition: 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 more expensive the expense ratio becomes. Higher tax is a result of capital gains distributions. These taxes travel from the fund managers’ trading costs to the investor’s returns. So, a fund with a High Portfolio Ratio will generate higher taxes than a fund with Low Portfolio Turnover Ratio.
How can Portfolio Turnover Ratio Help in evaluating mutual funds?
The Portfolio Turnover Ratio evaluates 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 the fund managers leads to 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. But 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, the investors are forced to face loss in the capital when the higher expense ratio does not come with high returns. The investors thus end up paying higher fund management costs without getting proper returns.
Investors tend to avoid investing in funds with high Portfolio Turnover Ratio due to the high expense ratio. But they miss out on the chance to get higher returns that could have been achieved by investing in superior funds with consistent performance.
Besides, following are a few other things that should be kept in mind:
- Index funds generally have a low turnover ratio, but they can provide higher returns
- Comparatively, smaller or new funds tend to have a higher PTR
- The PTR of funds with Growth Investing strategy is higher than funds with value investing strategy
- PTR is more appropriate for funds having exposure in equity
The investors must understand all the influencing factors before investing in getting the required returns. Many other ratios other than PTR should be used while analysing the funds. More importantly, each investor has their own objective and risk profile. The PTR can help the investor to choose the correct investment option by balancing their risk appetite with the fund’s risk level.