Portfolio Turnover Ratio – What is it, Calculation, Importance

As an investor, you surely do not want to lose your hard-earned money while making any investments. To combat risks, you must analyse a variety of mutual fund metrics that can tell you more about the performance of the fund. One such metric is a portfolio turnover ratio.

What is a portfolio turnover ratio?

The portfolio turnover ratio is defined as the rate at which portfolio managers change assets in a fund portfolio over a year. It is indicated in percentage terms. For instance, if the mutual fund you’re evaluating has 200 stocks, and has changed 100 stocks in the past year, then it means it has a portfolio turnover ratio of 50%.

A ratio of 100% or greater indicates that all the securities in the fund were either sold or replaced with other holdings over a one-year period. Any other figure less than 100% indicates that part of the portfolio that has undergone change in the last one year.

By nature, passively managed funds have a lower portfolio turnover ratio as against actively managed funds as passively managed funds try to replicate the index as closely as possible and components of an index don’t change often. 

Calculation of Portfolio Turnover Ratio

It is mathematically calculated as – 

• Portfolio Turnover Ratio = Minimum of Securities Bought or sold/ Average Net Assets * 100
• Where,
• Minimum of Securities moved is the total amount of new securities purchases in the reference period.
• Average Net Assets is the average monthly sum of total assets.

Let’s look at an example to understand this better:

A mutual fund has sold Rs 10 million worth of assets in one year. The net assets of this fund (on average) were worth Rs 50 million. With these numbers, the turnover ratio for this mutual fund would be calculated as:

(10 Million / 50 million) x 100 = which is 20%

Implications of Changes in Portfolio Turnover Ratio

The ratio affects the investment return of the fund – a lower turnover ratio is desired as that would mean lesser costs. The lower the turnover ratio, the more beneficial it is, as the capital gains tax incurred would be lesser due to the lower transaction costs. To put things into perspective, a portfolio turnover ratio is considered to be low if it amounts to less than 30%. 

A high turnover ratio is only justifiable if the fund manager ensures there are higher returns.

If there is a higher portfolio turnover ratio, then it implies that there is a higher churning of the assets in the portfolio, that there are higher costs involved in the fund’s management and that the market condition is dynamic.

The differences in two figures of the portfolio ratio after a period of time is indicative of the changes in the investment strategy of the fund manager over the said period.

Portfolio turnover ratio and its relationship with Index funds

Index funds are typically classified as passively managed funds. As a result, they have a low turnover rate as the fund managers don’t change stocks frequently to optimise the performance. A low turnover rate is generally considered a good sign when evaluating an index fund. 

Importance of Portfolio Turnover Ratio

• It provides an accurate picture about fund management.
• It reveals the fund manager’s strategy.
• It will also influence the expense ratio of the fund.
• Also enables one to assess discrepancies. Say the expense ratio and portfolio turnover ratio is high but the returns are not commensurate, then it will indicate that there is some mismanagement of the fund by the fund manager.

Turnover and Mutual Fund Quality

The replacement of the holdings in a mutual fund is depicted through the turnover. The quality of the fund is higher if the fund is lower. But this is not necessarily the only litmus test.  The indicators, such as expense ratios, load/no-load, management tenure, investment philosophy, and performance must be looked into alongside to determine the quality of investment.

Some Important Pointers

• Index funds might provide a higher return but have a low turnover ratio. Using portfolio turnover ratio might be misleading.
• Small cap funds and newer funds tend to have a higher portfolio ratio as the stocks are often replaced regularly. But this metric must not be seen in isolation – instead, it must be read with other equally important indicators.
• This metric is more appropriate for equity funds, or those funds which have some equity exposure as these are long-term investment funds and can handle a few assets being moved around every once in a while.
• Investors must always compare one’s investment objective and risk appetite to the returns generated and the risks undertaken to see if the fund was worth the investment and not solely rely on the portfolio turnover ratio.

When selecting a mutual fund to meet your investment goals, you must look at the portfolio turnover ratio to determine whether the fund is being properly managed. High turnover ratios can indicate a variety of factors such as a change in the fund’s objectives, a new portfolio manager, or poor performance. Being wary of the same can help you prevent losses in the future. 

FAQs

1. What is a portfolio turnover ratio?
   The portfolio turnover ratio is a percentage term that shows the rate at which  portfolio managers move assets in a fund over a year.

2. What can you learn from the portfolio turnover ratio?
   You can get an idea of the fund manager’s strategy and then decide whether you’d like to invest in the fund accordingly.

3. Is a high turnover a bad thing?
   Not necessarily – if the fund manager can ensure that the returns justify the high turnover, then a high portfolio turnover should be fine.