What is portfolio turnover ratio? How can it help while investing in mutual funds?

Investing in mutual funds can be a rewarding way to potentially grow your wealth over time. However, the world of mutual funds is filled with terminology and metrics that may seem overwhelming to the novices. One such metric that often perplexes investors is the portfolio turnover ratio. Whether you are a novice investor or someone with experience, understanding the portfolio turnover ratio can be a valuable tool in your financial portfolio.

So, what is portfolio turnover ratio in mutual fund and how does it impact one’s investment strategy?

• Table of contents

1. What is portfolio turnover ratio?
2. Significance of portfolio turnover ratio
3. Making informed investment decisions
4. What does a high Portfolio Turnover Ratio indicate?
5. What does a low Portfolio Turnover Ratio indicate?
6. Importance of portfolio turnover ratio
7. How to calculate portfolio turnover ratio in mutual fund?

What is portfolio turnover ratio?

Before we explore its significance, let's begin by demystifying the portfolio turnover ratio itself. The portfolio turnover ratio in a is a numerical expression of the frequency with which the fund manager buys and sells securities within the fund's portfolio. This ratio is typically expressed as a percentage and represents the proportion of the fund's assets that are traded within a specific time frame, usually a year. In essence, it quantifies how actively or passively the fund manager is managing the fund's investments.

Significance of portfolio turnover ratio

Now that we've understood the meaning of the portfolio turnover ratio, let's discuss why it matters to investors in mutual funds.

Risk vs. reward: A high portfolio turnover ratio indicates that the fund manager is actively buying and selling securities within the fund. This active management may potentially lead to a relatively better return potential. However, it also comes with a caveat – relatively higher transaction costs. Frequent trading within the fund incurs brokerage charges. As an investor, understanding this trade-off is crucial to align your investments with your risk tolerance and financial goals.

Costs matter: High turnover ratios often result in higher transaction related cost. The increased trading activity within the fund incurs costs, which are passed on to investors. Consequently, as a prudent investor, it's essential to consider not only the potential returns but also the costs associated with a mutual fund. Over time, high expenses may eat into your returns, significantly eroding the wealth you've diligently built.

Making informed investment decisions

Now that you grasp the meaning and significance of the portfolio turnover ratio, how can you leverage this knowledge to make informed investment decisions?

Align with your goals: Begin by defining your financial goals and assessing your risk tolerance. Understanding your objectives is paramount in selecting a suitable mutual fund scheme. If you aim for long-term wealth generation and are comfortable with a lower degree of active management, funds with lower turnover ratios may be more suitable.

Review historical data: Check out the fund's historical turnover ratios. Consistency is key. A fund that maintains a certain level of turnover over time indicates a particular investment strategy. Funds with consistently high turnover may signal a more aggressive approach, while those with consistently low turnover suggest a passive strategy. Choose funds that align with your investment philosophy.

What does a high portfolio turnover ratio indicate?

Frequent trading activity: A high PTR indicates that the fund manager actively trades securities, making frequent buy-and-sell decisions based on market movements or specific stock opportunities. This generally reflects a more aggressive investment style.

Potential for increased costs: Frequent transactions can lead to higher brokerage fees. These additional costs may reduce returns and affect the fund’s overall performance.

Potential for increased returns (along with higher risk): While a high PTR may result in better potential returns in favourable market conditions, it also involves a higher level of risk.

What does a low portfolio turnover ratio indicate?

Passive or buy-and-hold strategy: A low PTR typically means the fund manager holds onto securities for extended periods, following a long-term investment approach.

Potential for lower costs: Less trading activity often results in reduced transaction costs, such as brokerage fees and other expenses, which can help preserve fund returns.

Potential for relatively steady returns: While a low PTR does not ensure returns, it reflects a less volatile approach that may lead to relatively steadier performance over time.

Importance of portfolio turnover ratio

The portfolio turnover ratio (PTR) is a key metric for investors as it provides insights into a mutual fund’s management approach, costs, and potential tax consequences. Here’s why it is relevant:

1. Investment approach: PTR can indicate the fund manager’s strategy. A high PTR may suggest a focus on short-term opportunities, while a low PTR could reflect a long-term, buy-and-hold philosophy.

2. Assessing costs: Frequent trading leads to higher costs, such as brokerage fees. A high PTR typically means higher expenses.

3. Expense ratio impact: While not directly related, a high PTR can contribute to a higher expense ratio if the fund incurs significant transaction costs.

4. Making informed investment choices: Understanding PTR helps investors select funds that match their investment goals and risk tolerance. For example, a long-term investor seeking lower costs and tax efficiency may prefer a fund with a low PTR.

5. Comparing funds: PTR is useful for comparing funds within the same category. However, other aspects like performance, risk measures, and expense ratio should also be considered before making a decision.

How to calculate portfolio turnover ratio in mutual fund?

The turnover ratio of a mutual fund is calculated based on the lesser of total purchases or total sales of securities made by the scheme over a period, usually one year. The first step is to determine this ‘lesser amount’, which represents the value of capital gains, whether short-term or long-term, generated through trading activity.

For example, if the total purchase of securities by a mutual fund scheme during the year was Rs.1000 crore and total sales amounted to Rs.900 crore, the lower or lesser value would be Rs.900 crore. This step helps account for instances where the fund manager replaces only a portion of holdings rather than the entire portfolio at one go.

The next input required is the Average Monthly Net Assets (AMNA) of the scheme, which is used as the denominator to annualize the ratio. AMNA is calculated by taking the daily net assets of the fund over the period and computing their monthly average. This helps account for any significant net subscriptions or redemptions over the year.

The formula to calculate the portfolio turnover ratio is
Lesser of Total Purchases or Total Sales during the Year ÷ Average Monthly Net Assets
Using the previous example, if the AMNA of the fund was Rs.1000 crore:
Rs.900 crore ÷ Rs.1000 crore = 0.9
To annualize this ratio, it is multiplied by 100 to report it as a percentage depicting the rate at which the portfolio was replaced in that one year.
In this case, the portfolio turnover ratio would be: 0.9 x 100 = 90%

conclusion

In conclusion, the portfolio turnover ratio in mutual funds is a valuable metric that warrants careful consideration when making investment decisions. It offers insights into a fund's management style, and potential risks. While it's a crucial tool in your investment toolkit, remember that it's not the sole determinant of a fund's performance. However, understanding the portfolio turnover ratio can empower you to make informed choices, ultimately steering your financial future in the right direction. As you embark on your mutual fund investment journey, remember to consult a financial advisor or distributor. These experts can help you tailor your investments to your specific financial needs and objectives.

FAQs:

What is the portfolio turnover ratio?

The portfolio turnover ratio is a financial metric that measures the frequency with which assets within a mutual fund or portfolio are bought and sold within a specific time frame, typically a year.

Why is the portfolio turnover ratio important for investors?

The portfolio turnover ratio can provide insights into a fund manager’s strategy. Investors must always compare their investment objective and risk appetite to see if the fund is worth the investment and not solely rely on the portfolio turnover.

How does a high portfolio turnover ratio impact mutual fund returns?

A high portfolio turnover ratio indicates frequent trading of securities, which can lead to higher transaction costs such as brokerage fees, which can affect returns. While some turnover is justified in active management, excessive turnover can lower returns. Investors should assess this alongside the expense ratio.

What is considered a good portfolio turnover ratio in mutual funds?

There is no concept of a ‘good’ portfolio turnover ratio that is suitable for all funds. It varies based on the fund’s strategy and investment objective. Actively managed funds aiming for higher returns may have higher turnover, while passively managed index funds tracking a benchmark generally have lower turnover. Investors should consider turnover in relation to the fund’s goals and expense ratio. Within active funds too, the strategy of the fund manager can dictate turnover ratio, which some manages preferring buy-and-hold approaches and others following a more trading-oriented strategy.

Does a low portfolio turnover ratio mean better investment stability?

A low portfolio turnover ratio reflects less frequent trading within the fund, often aligning with a buy-and-hold strategy that may contribute to relatively stable performance in the long term. However, it does not ensure stability, as market movements can still affect the fund's Net Asset Value (NAV). Other elements, such as asset allocation and risk management, also influence stability.

How can investors use the portfolio turnover ratio to choose a mutual fund?

The portfolio turnover ratio can be one of the factors investors consider when selecting a fund. A lower ratio may be suitable for those preferring a relatively stable investment approach with lower transaction costs. A higher ratio might be acceptable for investors in actively managed funds seeking potentially higher returns, provided they are comfortable with the costs and tax implications. It should be assessed alongside factors like expense ratio, investment strategy, and risk tolerance.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.