Portfolio Turnover Ratio : Meaning, Importance, How to use it

Portfolio Turnover Ratio (PTR) tells you the entire story about the buying and selling activity happening within a fund. This article covers the following:

What is Portfolio Turnover Ratio?

Portfolio turnover ratio indicates the frequency with which the fund’s holdings have changed over the past year. In other words, you may perceive it as turning over of asset under management. It is expressed in percentage terms. 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. You may find it in the monthly fact sheet of a mutual fund scheme. 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). .    

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 1,200 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.  

What is the 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 holds strategy. It means that the fund manager is confident about his stock purchases. Moreover, he plans to keep 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 the underlying index. Consequently, there’s not much trading activity resulting in low 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 an active investing strategy. Aggressive trading entails transaction costs, thereby increasing the 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 the 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 PTR to select mutual funds?

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! When the fund manager is trading securities in the portfolio, he is contributing to the expense ratio by way of transaction costs. If the frequency of churning is high to tap the opportunity, it might lead to an increase in the portfolio turnover ratio. However, such kind of churning should reflect as higher risk-adjusted returns for the fund. The returns of the fund need to increase to commensurate with the increase in the expense ratio.

On the contrary, if the steady increase in turnover ratio and expense ratio is not being reflected in your returns, then it is a matter of concern. There can be a number of reasons for this anomaly. Chances might be that the fund manager is clueless about the market movements. And he is just churning the portfolio as a hit and trial method to arrive at the ideal stock picking. 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 the Sharpe Ratio to derive real sense out of the 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.  

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