You pick your Mutual Funds based on various aspects such as your risk appetite, type of sectors and firms underlying the fund, long-term Compound Annual Growth Rate (CAGR), fund manager’s strategy, etc. If you get confused by returns due to volatility in the market, you also take a look at the portfolio turnover in order to assess how the fund manager manages a portfolio.
Turnover ratio, in Mutual Fund jargon, refers to a measure of how a fund portfolio changes in a year. The ratio indicates how a fund is trading. In this article, we will discuss the turnover ratio and how it impacts your investment.
Turnover ratio – a measure of changing portfolio
It is measured as the ratio of assets added or sold to the average holding for the year. Suppose a Mutual Fund has 10 companies in its portfolio and the fund manager decides to drop two companies comprising of 12% of the total value either due to bad performance or change in the fund manager’s preference, etc. The turnover ratio of the fund for that year would be 12% assuming the average holding for the year doesn’t change.
Impact on Mutual Fund investors
Every time there is trading, the investor has to incur brokerage and transaction charges on the fund’s behalf. Hence, turnover ratio extracts a price on investors. This is the most direct impact of trading on investment. Needless to say, a high turnover ratio will incur high brokerage charges. On the contrary, a lower turnover ratio would provide stability to your investment.
Is high turnover ratio bad?
The answer depends on whether the fund has given good returns after a change in the portfolio. If the return has improved because of high turnover, it’s worth the cost. However, a high turnover ratio combined with poor returns is a problem.
What investors need to keep in mind
The turnover ratio is generally high in rising markets because there are many opportunities in the market at such times. A rising market is, after all, the result of a rising economy. There are many well-performing companies which give a plethora of choices to the investor. Hence under-performance by existing companies in the portfolio prompts the fund manager to replace them. Moreover, funds compete with one another in terms of returns, prompting fund managers to churn the portfolio.
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On the other hand, in a subdued market, there aren’t many opportunities, and fund managers may be wary of letting go of stocks. Any churn will eat into returns because of brokerage charges which are already low because of a falling market.
While selecting a fund you must analyse the turnover ratio along with the returns. It will also make your investment more informed. Remember, a low turnover ratio is of no use if the returns are low, while a high turnover ratio is not a problem if the fund gives above-average returns.
Finally, while turnover ratio should be looked at, do not forget to check other parameters such as the expense ratio. The expense ratio is a combination of the fund manager’s fees, administration charges, and other associated charges.
(The writer is CEO, BankBazaar.com)