Why portfolio turnover is the key when evaluating mutual funds - Motilal Oswal
Why portfolio turnover is the key when evaluating mutual funds - Motilal Oswal

Why portfolio turnover is the key when evaluating mutual funds

When we evaluate a mutual fund performance we normally assess it on a variety of parameters. The most straightforward measure is the returns of the fund over a longer period of time and whether it has outperformed the index like Nifty. The second measure is whether the fund in question has outperformed its peer group and whether it is able to do it consistently. But returns alone are not enough. These returns must be generated with an acceptable level of risk. That is where measures like Sharpe and Treynor are useful in measuring the risk-adjusted returns of the fund. Then there are more subjective factors like the longevity of the fund manager, the image of the AMC group etc. But aside from all these factors there is another important factor when it comes to equity funds and balanced funds and that is the concept of Portfolio Turnover ratio..

Understanding portfolio turnover ratio..
As mentioned earlier, the portfolio turnover ratio is more relevant for equity funds and balanced funds, not so much for debt funds. Portfolio turnover measures how frequently the fund manager churns over the complete portfolio. The transactions are considered on a rolling annual basis but the net assets of the fund are calculated as of each month end. Let us understand the calculation of portfolio turnover ratio with an illustration..

Variable (for Fund Alpha)AmountExplanationTotal buy transactions between Dec 2016 and Nov 2017Rs.880 croreThis is the sum of all purchases made by the fund during the 1 year periodTotal sell transactions between Dec 2016 and Nov 2017Rs. 860 croreThis is the sum of all sales made by the fund during the 1 year periodLower of the above 2 (A)Rs.860 croreThe lower of the above 2 is considered to avoid double countingNet Assets as on November 30th 2017 (B)Rs.700 croreThis is the AUM adjusted for liabilities and payables as on last trading day of NovemberPortfolio Turnover Ratio1.23 times or 122.85%Calculated as the quotient of  (A) and (B)

There are no hard and fast rules for what the portfolio turnover ratio should be. Ideally, 100% is taken as the cut-off. Up to a portfolio turnover ratio of 100% is acceptable. In the above case, the portfolio turnover ratio is 122.85%, which is definitely on the higher side. The fund manager has to actively manage the fund and therefore portfolio turnover is part of the game. However, it must not become excessive. Remember, you invest in equity funds for the long term. There is really no strong justification for the fund manager to constantly keep churning the portfolio. Instead, the focus should be to identify quality stocks and stick to his guns. While funds are statutorily required to disclose the portfolio turnover ratio only twice a year, most equity and balanced funds disclose the portfolio turnover as part of their fund fact-sheets every month. As an equity fund holder, you need to constantly review the portfolio turnover ratio and the trend is more important. If you find the portfolio turnover ratio rising and the performance of the fund dipping, then it is a matter of worry for you as investor in the fund.

3 things you need to know about the Portfolio Turnover Ratio..

Normally, the portfolio turnover ratio tends to be high for small funds with a corpus of less than Rs.100 crore. That is understandable. As a mutual fund investor a small fund having a ratio of over 100% is acceptable, but not a large fund with a much bigger corpus.

The reason portfolio turnover works against you is that there is a cost attached to portfolio turnover. There are transaction charges, there are statutory charges and then there are costs in terms of missed opportunities. Normally, higher turnover is synonymous with higher loading and that impacts portfolio returns.

During bullish market conditions, funds have been observed to outperform even when the turnover ratio is high. The real test comes when the markets are flat or bearish. It is here that it becomes more important to keep the portfolio turnover under a tight leash.

Is there a relationship between portfolio turnover ratio and returns? Let us consider the table below..

Name of FundPortfolio Turnover RatioFund returns   Edelweiss Prudent Advantage432%12.63%Baroda Pioneer Growth156%15.36%Taurus Ethical Fund128%15.30%   Franklin India Oporto Fund12%18.67%Franklin India Prima Plus9%19.86%Templeton India Growth7%17.62%

                                 Source: Value Research

The portfolio turnover is considered for an average of 5 years or since inception if less. There definitely appears to be a relation in the sense that lower portfolio turnover is propping up returns. Remember, this is during a period when 4 out of the 5 years have been bullish years. When we look at a more tepid year, these differences could become starker. That could be the biggest takeaway!

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