Portfolio Turnover

The focus in India has always been skewed towards active management of funds be in terms of stock selection or active buying and selling, and this active fund management to an extent has been reflected in the fund performance too. However investment theories invariably favors the benefits of long term investing as true value unlocking of any holding happens over a long period of time whereas, on the other hand frequent churning increases the expenses in terms of brokerage and taxes and thus lower returns.

Portfolio turnover ratio assumes importance here as it provides some meaningful information on the fund’s investment strategy. It is defined as the lesser of securities sold or purchased during a year divided by the average of daily net assets. A ratio of 100% means that fund changes its portfolio once over the year.

The long term investing is the best way to take advantage of equities; the factors that really induce portfolio churning are the style of investing and the prevailing market conditions. Investment managers often point that given the volatile trends in Indian market and extensive potential of equities portfolio churning is indispensable. For example, if the markets are booming and the fund has achieved its targeted return then it may prefer to churn its portfolio and invest in some more defensive stocks than it otherwise would have. Similarly if the markets are range bounds changing the portfolio composition may help to realize better gains. 

Another important factor not to be ignored is market sentiments, which often forces fund managers to include momentum picks in their portfolio and however this a short-term strategy but nonetheless it adds to the churning rate. Also factors like unexpected redemption and change in fundamentals of the company may influence the fund manger to offload the securities. At the same time correction in the market provides them the significant opportunity to buy the stocks and deploy surplus cash if any which in turn impacts the portfolio turnover ratio.

Although there is no direct correlation between portfolio turnover and performance, and high churning rate does not necessarily translates into better performance, but what it does mean is high costs for the fund. Therefore, an investor holding a fund with high turnover rate is justified in feeling that he should he compensated in terms of returns for all the extra costs that the fund is incurring. Over time, portfolio turnover rate becomes an important number to look out for while selecting a fund and informed investors will be well advised to look for best of both the worlds.

Each buys and sell transaction in the stock markets involves a brokerage cost. This brokerage cost has to be borne by the mutual fund, which in turn passes it on to its investors. So investors have to pay for the trading carried out by the fund on their behalf. Obviously, higher the volume of trading, greater will be the associated costs. And greater trading costs can definitely reduces returns. The turnover ratio provided the fund manager’s trading. The turnover ratio represents the percentage of a fund's holdings that change every year. To put it simply, a turnover rate of 100 per cent implies that the fund manager has replaced his entire portfolio during the period given. Higher the turnover ratio, greater is the volume of trading carried out by the fund.

The high turnover is bad or well, that depends on what it achieves. If high turnover can generate high returns, then there should be no problems. The problem arises when a fund is trading heavily and not generating commensurate returns. The turnover ratio is more important for equity funds where the trading cost of equities is substantial.