What is Portfolio Turnover Ratio? Insights and Impact

Investing in equity mutual funds comes with two major choices. One can identify a good stock and hold it for a long time. The second option is to keep looking for market opportunities and keep shifting the portfolio accordingly.

While the first strategy is a conservative strategy, the second strategy is in tune with volatile markets. Whether it is working or not, depends on the portfolio turnover ratio. Let us understand what is portfolio turnover ratio and how it affects your mutual fund investments?

What is Portfolio Turnover Ratio?

The portfolio turnover ratio or the PTR is a measure of how frequently and how aggressively the portfolio of the mutual fund is churned by the fund manager. A fund manager will buy stocks and also sell stocks based on the opportunities that arise. The portfolio turnover ratio puts such churning in perspective and tries to figure out whether the portfolio turnover ratio in mutual funds is excessive, moderate, or possibly too low. Estimate your mutual fund returns more effectively using a SIP Calculator especially when analyzing metrics like portfolio turnover ratio.

How to Calculate Portfolio Turnover Ratio?

To calculate the portfolio turnover ratio, we need to learn how to apply the portfolio turnover ratio formula. In simple terms, the portfolio turnover ratio can be interpreted as the ratio of churn to the AAUM (average assets under management) of the mutual fund portfolio. The portfolio turnover ratio formula below will give a better understanding.

Portfolio Turnover Ratio = (Minimum of stocks bought or Sold) / AAUM

Here in the first part of the formula, you can consider the smaller value (between total purchases and total sales). The AAUM is the average assets under management of the fund in question and is normally the average of the lowest AUM and the highest AUM in a year.

The portfolio turnover ratio or PTR is normally expressed in percentage terms. Higher the portfolio turnover ratio, higher is the churn by the mutual fund and lower the portfolio turnover ratio, lower is the churn by the fund.

Practical Examples of Portfolio Turnover Ratio

Here is a practical live example of portfolio turnover ratio based on assumptions. We will apply the portfolio turnover ratio formula to two funds to compare how far they are on the portfolio turnover ratio front.

As you can see Fund A has churned nearly one-third of its portfolio in the quarter. That is considered to be reasonable. However, Fund B had a portfolio turnover ratio of a whopping 51.67%, meaning they churned more than half of their portfolio during the quarter, which is relatively higher.

What does a High Portfolio Turnover Ratio and Low Portfolio Mean?

Key points to remember about high and low portfolio turnover ratio while investing in mutual funds

• A fund with a high portfolio turnover ratio is obviously churning its fund too often. While the fund manager is not expected to be a typical buy and hold sort of investor, too much churn shows a level of instability in investment strategy.
• The second implication of a high portfolio turnover ratio can be the cost implication. Mutual funds also put buy and sell trades through brokers. Hence, such trades attract brokerage costs, STT, GST, exchanges, stamp duty and other statutory charges. Hence higher portfolio turnover ratio can add to the cost, enhance TER, and lower the NAV.
• Too much churn also shows that the fund may be losing out on opportunities that typically come from a patient and stable investment approach. Equities, after all, are a long term asset and too much churn goes against that formula.
• While looking at the portfolio turnover ratio, one must also look at market conditions. When markets are at high or low valuations, the churn could be high. The same is the case in volatile times. Hence provisions have to be made to keep these factors in mind when studying portfolio turnover ratio.

Importance of Portfolio Turnover Ratio

Let us understand why the mutual fund turnover ratio or the portfolio turnover ratio is critical to understanding the fund.

• Portfolio turnover ratio is a good basis for judging whether the fund manager is churning the portfolio too often. There are two implications of frequent churning of the portfolio. Firstly, the performance of the fund tends to become volatile as the full benefits of long term investing are not imbibed. Secondly, the churn also adds to the cost of the fund in the form of brokerage and statutory charges. This raises the total expense ratio (TER) of the fund and also reduces the NAV returns on the fund. That is a double whammy.
• The portfolio turnover ratio is a good basis for comparing two similar funds. One must ensure that they are comparing apples to apples and not to oranges. There is no point comparing the portfolio turnover ratio of an active equity fund with a passive fund. The former will obviously have a higher churn. Like comparisons give a good picture if the fund is churning too much and whether such a churn is impacting the returns on the fund. That is normally a red flag.

However, very low churn is also not too good since the fund manager needs to make an attempt to change strategy with the times.

How to Use Portfolio Turnover Ratio to Evaluate Mutual Funds?

There are several ways to use portfolio turnover ratio to take a fund call, based on what is called the mutual fund turnover ratio.

• Look at the portfolio turnover ratio in perspective. Is it too high or too low compared to the historical standards? Also, is it too high or too low compared to the peer group? That is a good way to evaluate PTR.
• Look at the return impact. If a higher portfolio turnover ratio has resulted in meaningfully higher returns, then it is probably worth it. The fund manager is, perhaps, being proactive. However, if it hits returns, then it can be a red flag.
• See the portfolio turnover ratio in the context of volatility in the market. In a volatile market, a higher turnover ratio is acceptable.
• Lastly, one needs to read the fund manager review to understand whether the portfolio turnover ratio fits with the broad strategy of the fund.

Conclusion

To sum up, the portfolio turnover ratio is a good way to evaluate whether the churn is worthwhile or not. Some churn is inevitable in an active fund and in volatile times, such churn may go up. However, if the high portfolio turnover ratio is impacting the performance of the fund, then it is a red flag.

Ideally, the funds can be compared to one another based on the portfolio turnover ratio. One must compare apples so that the findings are actually conclusive.