Are you concerned about your fund manager’s aggressive trading activity?
Do you want to analyse its impact on your mutual fund returns?
Then use “portfolio turnover ratio!”
Portfolio Turnover Ratio (PTR) reveals the entire story about the buying and selling activity happening within a fund. It is expressed in percentage terms. You may find it in the monthly factsheet of a mutual fund scheme.
PTR provides insights about a lot of things. It gives an idea about the fund manager’s overall investment strategy. You can understand the entire functioning of the fund by looking at the PTR.
Let’s have a brief understanding of PTR before delving deeper into its uses.
Portfolio Turnover Ratio: Meaning
Portfolio Turnover Ratio indicates the frequency with which the fund’s holdings have changed over the past one year. In other words, you may perceive it as turning over of asset under management.
You may find it in a factsheet of the fund. However, there’s a simple formula which you may use to determine a fund’s Portfolio Turnover Ratio. It is calculated by dividing the lesser of purchases/sales by average asset under management (AUM).
Portfolio Turnover Ratio = (Minimum of securities bought or sold)/Average AUM
Suppose the equity fund purchased Rs 300 crore of equity shares. In the same year, it sold Rs 400 crore of equity shares. The average AUM of the fund is Rs 1200 crore. Hence, the Portfolio Turnover Ratio of the fund is 25%.
It means that 25% or one-fourth of the assets of the portfolio were churned over the last one year.
Importance of Portfolio Turnover Ratio
Portfolio turnover ratio can provide clues about the manner of fund management. It reveals which kind of strategy the fund manager is using to generate returns on investment.
A low turnover ratio indicates a buy and hold strategy. It means that the fund manager is confident about his stock purchases. Moreover, he plans to hold them for the entire investment horizon of the fund. Automatically, such a fund will have a low expense ratio owing to low transaction costs.
Low portfolio turnover ratio might also be due to the fund category. In passive funds like index funds, the fund manager merely matches the funds’ holdings with that of underlying index. Consequently, there’s not much trading activity resulting in low a portfolio turnover ratio.
Funds having a high portfolio turnover ratio entail aggressive trading activity. The fund manager keeps buying and selling the securities to take advantage of the situation. You may witness a high Portfolio turnover ratio in funds following active investing strategy.
Aggressive trading entails transaction costs thereby increasing expense ratio of the fund. Consequently, funds having dynamic asset allocation might have a relatively higher expense ratio.
The level of portfolio turnover ratio also depends on market conditions. A highly volatile market causes the fund manager to sit tight thereby keeping turnover ratio at low levels.
On the contrary, a rallying market encourages fund manager to indulge in frequent trading; thereby increasing the portfolio turnover ratio.
How to use Portfolio Turnover Ratio in mutual fund selection?
Now you know that Portfolio Turnover Ratio can disclose numerous things about a mutual fund.
You might be wondering, “whether a high Portfolio Turnover Ratio is good or bad?”
It depends on circumstances!
If your fund manager is frequently churning the portfolio to tap the opportunity, a high Portfolio Turnover Ratio can be ideal. However, such kind of churning should reflect as higher risk-adjusted returns for the fund.
However, if it is not reflecting in your returns, then it is a matter of concern. Chances are that the fund manager is clueless about the market movements. And he is churning the portfolio as a hit and trial method.
In such a scenario, you might end up paying higher fund management expenses without getting corresponding higher returns.
Hence, it is very important to consider other ratios like Sharpe ratio to derive true sense out of Portfolio Turnover Ratio.
Apart from this, you need to align your investment objectives with that of the fund. If you believe in passive investing, then active investing might seem a costly proposition. Thus, based on Portfolio Turnover Ratio and objective, select an appropriate mutual fund.