What is portfolio turnover ratio?

Does your fund change its stocks frequently? Or does it sell a lot to book profits or buy more on dips? How do you gauge these? Portfolio turnover reveals this. It is a number that is disclosed at the end of the month in fund factsheets.

Comparing this ratio for a set of peer funds can give some insight on how the portfolio is managed.

Portfolio turnover ratio
As the name suggests, portfolio turnover ratio is the frequency with which the assets of the fund have been turned over. In other words, it denotes the percentage of fund holdings that have changed over the last one year.

It can be calculated by taking the minimum of the total value of stocks either bought or sold over the last one year divided by the average assets under management(AUM). Let us look at an example here.

If a fund has bought Rs 800 crore of stocks and sold Rs 900 crore of stocks with an average AUM of Rs 1600 crore, the turnover ratio of the fund is 20%. What does this 20% mean? It means on an average 20% of the assets of the scheme was churned over the last one year.

Why is it important?
Portfolio turnover will give you some idea on how the fund is being managed.
If a fund has a low turnover, it means that the fund follows a buy and hold strategy. In general, a low turnover means that the fund manager has high conviction in his picks and hopes that holding them will return well.It also means that the fund is not incurring too much expenses in buying and selling stocks. On the other hand, if you notice a fund having a turnover ratio of over 100%, it indicates that the portfolio has been churned over entirely. This means a very high buying and selling activity in the fund. Such high turnover will add to the expenses of the fund by means of transaction costs and may affect returns.

A high turnover ratio is not necessarily bad in all cases. Let me look at some examples where a high turnover is inevitable.

Often times, in a rallying market, one may see high turnover ratio while in a falling or volatile market fund managers may prefer to sit tight. This is a natural outcome of opportunities in the market.

Funds that have a dynamic asset allocation based on market valuations, too, may see a higher portfolio turnover.

If the fund, traditionally, or due to its underlying strategy,has a high turnover ratio, it implies that the fund relies on short term trades compared to a buy and hold strategy.For instance, in the case of arbitrage funds, where the fund manager will have to use derivatives (a short-term hedging strategy), it is inevitable that the portfolio turnover is very high, often at 1000% or more. For such funds, this ratio may not tell you much about the fund manager’s acumen. They have to be evaluated on other parameters of performance. Portfolio turnover may also shoot up temporarily when there is a change in the fund manager or any change in policy or fund strategy.

It can be noticed from the above table that, despite having a high turnover ratio consistently, ICICI Prudential Focused Bluechip Equity has time and again delivered above average category returns compared to its peers. At the same time, despite having a low turnover ratio, the Sundaram Growth fund has lagged its peers in returns.

How to use this ratio
You can compare the portfolio turnover of funds with similar strategies or within the same category. If a fund has a high portfolio turnover, you need to see if it has accordingly delivered higher returns, especially on a risk-adjusted basis. Otherwise, it means churning is not helping the fund.