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

The Portfolio Turnover Ratio (PTR) is a critical metric financial ratio that reveals how often the assets in a mutual fund are being bought or sold within a year. Simply the PTR shows the percentage of the fund’s holdings that were adjusted during that year, offering insights into the fund manager’s trading style whether it’s more passive or active.

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.  

Calculating the Portfolio Turnover Ratio

The formula for calculating the Portfolio Turnover Ratio is:

Portfolio Turnover Ratio = (Securities Bought or Sold) / Average Assets Under Management (AUM) × 100

Where:

• Securities Bought/Sold: The total amount of securities bought or sold during the year.
• Average AUM: The average of the fund’s assets over the same period.

Interpreting Portfolio Turnover Ratio

• Low PTR (Less than 30%): Implies a buy and hold strategy, with fewer transactions and lower costs.
• High PTR (Above 70%): Implies a more aggressive trading strategy, with frequent buying and selling of assets.

Example 

• A 5% turnover ratio means that 5% of the fund's holdings were bought or sold.
• A 100% turnover ratio means the fund replaced its entire holdings within a year.

Portfolio Turnover Ratio and Your Investment Strategy

Understanding the portfolio turnover ratio is essential when choosing a mutual fund, as it reflects the fund manager’s approach, costs, and potential returns.

• Low Turnover Ratio (Under 30%): Indicates a passive investment strategy, where the manager holds assets longer. It’s often cheaper because of lower transaction costs.
• High Turnover Ratio (Above 70%): Indicates active management, where the manager buys and sells frequently. While this may result in higher potential returns, it also increases costs and taxes.

Simplified Calculation for PTR

Let’s say a mutual fund bought and sold ₹60 crore worth of assets during the year. Over this period, the fund’s average AUM was ₹400 crore.

Portfolio Turnover Ratio = (Smaller value of bought/sold assets) / Average AUM = (₹60 crore / ₹400 crore) × 100 = 15%

This means that 15% of the fund's holdings were adjusted during the year, reflecting a relatively low turnover ratio and a more passive strategy.

Aggressive Trading and High Turnover

Now, imagine a different fund, which bought ₹200 crore worth of stocks and sold ₹250 crore of stocks. Its average AUM stands at ₹800 crore.

Portfolio Turnover Ratio = (Smaller value of bought/sold assets) / Average AUM = (₹250 crore / ₹800 crore) × 100 = 31.25%

This 31.25% turnover ratio reflects a moderately active trading style, where the fund manager is adjusting the portfolio more frequently.

High Portfolio Turnover Ratios vs Low Portfolio Turnover Ratios

The high turnover ratio indicates that the fund is being actively managed, but it also means that transaction costs are higher, which can eat into your returns. On the other hand, a low turnover ratio suggests passive management and lower costs, which is appealing for long-term investors looking to reduce fees.

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.  

The Risk-Return Tradeoff

Let’s consider two funds:

• Fund A has a turnover ratio of 120% and a Sharpe Ratio of 0.65 (a measure of risk-adjusted return).
• Fund B has a turnover ratio of 45% and a Sharpe Ratio of 1.05.

While Fund A trades more frequently, it has a lower Sharpe ratio, meaning that the returns are lower for the risk taken. This might indicate that the additional transaction costs are not justified by the returns. Fund B, with a lower turnover ratio, delivers higher returns relative to the risk involved, making it more attractive for investors seeking better risk-adjusted returns

How the Portfolio Turnover Ratio Affects Taxes

More frequent trading results in higher capital gains taxes. When a fund buys or sells securities at a profit, taxes are triggered. This means that funds with a higher turnover ratio often generate higher taxes, reducing the overall returns for the investor.

Tax Implications:

• High Turnover Ratio: Leads to more capital gains distributions and higher taxes.
• Low Turnover Ratio: Fewer transactions, resulting in fewer taxable events and generally lower taxes.

Key Takeaways

1. Low PTR Funds: Generally passive funds with lower transaction costs, suitable for investors focused on long-term growth.
2. High PTR Funds: Actively managed funds that have higher transaction costs, but may offer the potential for higher returns.
3. Comparison: Always compare PTR alongside other key metrics to understand the full picture before making investment decisions.

The Portfolio Turnover Ratio is a useful tool for evaluating mutual funds, but it should be considered as part of a broader analysis. By looking at PTR alongside other metrics like risk, returns, and tax implications, you can make smarter investment choices that align with your financial goals.

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