Mutual funds invest in stocks like regular investors. They buy and sell stocks resulting in portfolio churn.
What is the ideal portfolio churn? How should investors interpret it?
What is portfolio turnover ratio
The frequency with which the assets of the mutual fund are churned (turned over) over a period – say last one year – is captured by the portfolio turnover ratio.
It is calculated by taking the minimum of the total value of stocks bought or sold over the last one year divided by the average assets under management(AUM).
If ABC Equity Fund sold Rs 500 crores of stocks and bought Rs 600 crore of stocks with an average AUM of Rs 500, its turnover ratio is 100%. This means that the fund manager has churned the entire portfolio over completely in a span of one year.
How should you interpret the turnover ratio?
A common problem confronting investors is with respect to the ideal portfolio turnover ratio, if it all there is one.
In our illustration ABC Equity Fund has 100% portfolio turnover ratio. The ratio may seem high to some investors, while others may find it quite normal.
The difference in perspective is explained once you hold the fund by its investment objective/strategy.
If ABC Equity Fund is launched with the explicit aim of building gains for investors based on market conditions, then 100% portfolio turnover ratio can be considered normal.
However, if ABC Equity Fund has a buy and hold investment mandate, then a 100% portfolio turnover is too high and tells investors that the fund is not pursuing its declared investment strategy.
This makes the portfolio turnover ratio subjective and is best assessed in the perspective of the fund’s investment mandate.
Should you look at portfolio turnover at all?
Since the portfolio turnover ratio features in fund factsheets (fund houses must disclose it twice a year, although some disclose it monthly), investors wonder whether they must filter their fund selection based on the ratio.
Without doubt the portfolio turnover ratio is crucial; as we have seen it can give investors a heads up on whether or not the fund is true to its investment mandate.
However, when it comes to fund selection, the portfolio turnover ratio is not as important as risk measures, like standard deviation and Sharpe ratio.
Risk-adjusted returns are a more crucial parameter for fund selection.
Once you select mutual funds with superior risk-adjusted returns, you can then short-list them further on parameters like portfolio turnover ratio to ascertain which mutual funds are true to their style.
Investors have much to gain from most statistics / data published in factsheets and the portfolio turnover ratio is no different. However, the ratio has limited value on a standalone basis. It is more purposeful when used in conjunction with other parameters.