The portfolio turnover ratio measures how frequently the assets in a fund are traded by the portfolio managers within a year. A high turnover ratio shows that a large portion of the fund's assets has been bought and sold during the year. Such frequent trading reflects active management. On the other hand, a low turnover ratio indicates less trading and a more stable portfolio.
Using this ratio, several investors understand how actively a fund is managed. It must be noted that frequent buying and selling of assets can lead to increased transaction costs and higher taxes for the fund due to the frequent realisation of gains or losses. Let’s understand the portfolio turnover ratio in detail and see how it is calculated. We will also study its importance and learn the significance of high vs. low portfolio turnover ratios.
What is portfolio turnover ratio?
The portfolio turnover ratio in a mutual fund measure how much of the fund’s portfolio has changed in terms of its holdings. This change is calculated for a specific period, which is usually one year. For more clarity, we can also state that this ratio indicates the level of trading activity within the fund.
Generally, a ratio between 0% and 100% is expected. However, it can exceed 100% for funds that use more aggressive trading strategies, such as funds that frequently buy and sell assets to take advantage of short-term market opportunities.
Moreover, a portfolio turnover ratio of 0% means that the fund’s holdings have remained the same throughout the period; that is, no buying or selling occurred. On the other hand, a 100% ratio means the fund's entire portfolio was sold and replaced with new investments. Similarly, a ratio of 15% would indicate that 15% of the portfolio was changed.
By analysing the portfolio turnover ratio, investors can assess how frequently the fund's assets are traded. This way, they get to know about the fund's management style and whether it’s actively or passively managed. It is significant to mention that an actively managed fund with a high turnover ratio may incur higher transaction costs and increase the tax burden for investors.
How does a portfolio turnover ratio work?
The portfolio turnover ratio tells you how much of a fund’s portfolio has been traded within a year. For example, if a fund has a 25% turnover ratio, it means that 25% of the holdings were bought or sold over the year. A turnover ratio of 100% or more means that the entire portfolio was either sold off or replaced with new investments within that time frame. Such a ratio shows very active management.
It is worth mentioning that generally, a low portfolio turnover ratio is preferred. That’s because it involves fewer trades, which results in lower transaction costs. Moreover, funds with high turnover are more likely to generate capital gains, which results in higher taxes for investors.
However, a high turnover ratio isn't always bad. If the fund manager is skilled and can achieve higher returns (compared to similar funds) despite the higher trading activity, the additional costs from frequent trades can be justified. This is particularly true if the returns are:
- Adjusted for the risk taken by the fund and
- Outperforming a standard benchmark, like a stock market index
In such cases, the benefits of higher returns outweigh the extra costs associated with a high turnover ratio. However, if a fund has a high turnover ratio and is underperforming its benchmark, investors should consider looking for other funds with lower costs and better performance.
What is a good portfolio turnover ratio
Determining a "good" portfolio turnover ratio isn’t just choosing a universal number that suits all funds. This ratio varies on the basis of the fund's investment strategy. When analysing this data, investors should often ask questions like:
- Whether the manager is selling underperforming assets (losers) or taking profits from successful ones (winners)
- How long does the manager usually hold onto stocks before selling?
- Does the manager evaluate the success of trades after they happen?
- How does the current turnover ratio compare to the fund’s historical turnover levels?
To fully understand the impact of the turnover ratio, investors can also conduct a performance attribution analysis. Through this analysis, investors can understand how the fund is generating its returns and what factors are contributing to the performance of the fund.
Formula for the portfolio turnover ratio
Using the portfolio turnover ratio, investors can assess how often a fund's assets are traded within a year. The formula is:
Portfolio Turnover Ratio = (Minimum of securities bought or sold) / (Average net assets ) x 100
Where,
- The minimum of securities bought or sold is the least value of total securities sold or purchased during the year.
- Average net assets are the average value of the fund’s assets over the year.
How to calculate portfolio turnover ratio?
Portfolio turnover ratio can be calculated by dividing the total value of securities sold or purchased by the fund, whichever is lower, by the average net assets of the fund in the same period. For example, if a fund has an average net asset value of Rs. 100 crore and it sells securities worth Rs. 40 crore and buys securities worth Rs. 50 crore in a year, then its portfolio turnover ratio is 40% (40/100).
Practical examples of portfolio turnover ratio
Example 1: Showing the calculation of a portfolio turnover ratio
Say a mutual fund in India purchased securities worth Rs. 100 crores and sold securities worth Rs. 80 crores over a one-year period. The fund had average net assets of Rs. 500 crores during this time. Now, using this data, we can calculate the portfolio turnover ratio as:
Portfolio Turnover Ratio = (Minimum of securities bought or sold) / (Average net assets ) x 100
Portfolio Turnover Ratio = (Rs.80 crores) / (Rs.500 crores ) x 100 = 16%
While making the above calculations, we divided the lower of the two amounts (Rs. 100 crores and Rs. 80 crores) by the average net assets (Rs. 500 crore) and then multiplied by 100. Thereby, we found that the fund’s portfolio turnover ratio is 16%, which means the fund’s portfolio changed by 16% over the year.
Example 2: Interpret the investment strategy of a fund through the portfolio turnover ratio
Say there is a mutual fund that focuses on taking advantage of shifting market conditions. This fund has a portfolio turnover ratio of 95% and follows an aggressive investment strategy.
Now, this suggests that the fund is actively buying and selling securities. Such a high turnover indicates that the fund manager frequently adjusts the portfolio to respond quickly to market changes. Their aim is to maximise returns in the short term.
Importance of portfolio turnover ratio
The portfolio turnover ratio measures how often a fund manager buys and sells assets within a portfolio. A low ratio suggests a buy-and-hold strategy. This implies a manager is confident in their stock picks and intends to keep them for a long time. This approach usually results in lower costs as there is less frequent trading, which leads to a lower expense ratio. Such strategies are common in passive funds, like index funds, where the goal is to mirror the performance of an index with minimal trading activity.
On the other hand, a high portfolio turnover ratio indicates an active management strategy. Here, the fund manager frequently trades to capitalise on market opportunities. However, this aggressive trading leads to higher transaction costs, which increases the fund’s expense ratio.
It must be noted that funds with dynamic asset allocation or those that actively try to outperform the market often exhibit higher turnover ratios. The increased trading reflects the manager’s efforts to adapt to changing market conditions quickly.
Moreover, the portfolio turnover ratio can also fluctuate based on market conditions. Let’s see how:
- In volatile markets, most managers trade less. This results in a lower turnover ratio, as they prefer to wait out the uncertainty.
- Conversely, in a rising market, managers trade more frequently to maximise gains, leading to a higher turnover ratio.
Hence, through an analysis of portfolio turnover ratio, investors can check a fund's strategy and learn how it responds to different market environments.
High vs. low portfolio turnover ratio in mutual funds
Depending on the portfolio turnover ratio, mutual funds can be classified into high turnover funds and low turnover funds. Here are some of the characteristics and implications of both types of funds:
- High turnover funds have a portfolio turnover ratio of more than 100%, which means that they replace their entire portfolio at least once in a year. These funds are usually more aggressive and aim to capture short-term market opportunities. They may generate higher returns in a bullish market, but they also incur higher transaction costs, brokerage fees, which reduce the net returns for the investors. High turnover funds also tend to be more volatile and risky, as they are more exposed to market fluctuations.
- Low turnover funds means that they retain their portfolio for more than two years on average. These funds are usually more conservative and follow a buy-and-hold strategy. They may generate lower returns in a bullish market, but they also save on transaction costs, brokerage fees, which increase the net returns for the investors. Low turnover funds also tend to be more stable and less risky, as they are less affected by market fluctuations.
How portfolio turnover ratio assists mutual fund assessment
Portfolio turnover ratio is one of the important factors that can help you assess the performance and suitability of mutual funds for your investment goals. Here are some of the ways that portfolio turnover ratio can assist you in mutual fund assessment:
- Portfolio turnover ratio can help you understand the investment style and strategy of the fund manager. You can compare the portfolio turnover ratio of different funds in the same category and see which one matches your risk appetite and return expectations. For example, if you are looking for a long-term investment with low risk and steady returns, you may prefer a low turnover fund over a high turnover fund.
- Portfolio turnover ratio can help you evaluate the efficiency and effectiveness of the fund manager. You can compare the portfolio turnover ratio of a fund with its benchmark index and see how well the fund manager is able to beat the market.
Taxes and PTR
When a fund manager frequently buys and sells stocks, it increases the fund's costs, which raises the expense ratio. Additionally, these frequent trades result in capital gains, which are taxed as per the various provisions of the Income Tax Act. The tax liability so arising reduces the returns that investors receive.
Therefore, a fund with a high portfolio turnover ratio will generally lead to higher taxes for investors compared to a fund with a low ratio. So, more trading within the fund leads to higher costs and taxes, which ultimately impacts the investor's overall returns.
When not to use the portfolio turnover ratio
The portfolio turnover ratio isn't useful for all types of funds. This ratio can be misleading for debt funds, where the focus is on interest rates. That’s because debt fund managers usually trade debt securities when interest rates change, but the portfolio remains largely the same if rates are stable. Also, trading costs in the fixed-income market are generally low, so a high portfolio turnover ratio doesn't significantly affect expenses.
The portfolio turnover ratio is again less relevant when it comes to index funds. These funds simply mirror the holdings of an index, meaning the fund manager buys stocks according to the index's composition. Since the portfolio only changes when the index itself changes, the portfolio turnover ratio is naturally low and doesn't provide meaningful insights into the fund’s performance.
Similarly, portfolio turnover ratio is less useful for arbitrage funds. These funds frequently trade in highly liquid derivatives with short expiry periods. As a result, a high ratio is certain but doesn’t reflect unnecessary trading or poor management.
Therefore, when evaluating a fund manager’s performance, the portfolio turnover ratio should be used along with other indicators, such as:
- Returns compared to a benchmark
- Risk-adjusted performance
- Consistency in delivering good results
Key learning points
- The portfolio turnover ratio measures how much of a fund's investments have been bought or sold over a specific period, usually one year.
- This ratio shows how actively a fund manager is trading the portfolio's assets.
- To calculate the turnover, you take the least value of the total purchases or total sales of the fund's investments (excluding short-term securities) and divide it by the average value of the fund's assets over the year.
- A low turnover ratio suggests that the fund manager follows a buy-and-hold strategy. This implies they hold onto investments for a longer period.
- A high turnover ratio shows frequent trading and a strategy that aims to time the market for short-term gains.
- However, higher turnover also leads to increased transaction costs and more taxes. This negatively impacts the overall returns generated by investors from their investments.
Conclusion
Thus, portfolio turnover ratio is a useful metric that can help you understand and compare the performance and suitability of mutual funds for your investment goals. However, it is not the only factor that you should consider while investing in mutual funds. You should also look at other factors such as fund performance, fund objectives, fund size, fund ratings, fund manager’s experience, and fund diversification.
Note: After you have performed the required analysis and identified the funds you want to invest in, you can simply click on the “Explore Funds” button on top of this page and check out 1,000+ schemes available to investors. Investing through the Bajaj Finserv Mutual Funds platform is quite easy and hassle-free, and you can choose to make a lump sum or SIP investment in the funds of your choice.
