When choosing a mutual fund, how do you decide if a particular scheme suits you? You may look at trailing and rolling returns, benchmark outperformance, volatility, downside and upside capture etc. But one neglected metric is the portfolio turnover ratio. It can tell you a lot about what’s happening behind-the-scenes in a fund.
What is it
Portfolio turnover ratio is the number of the times the securities in a scheme’s portfolio are churned in a period. Though more than one formula is in vogue to calculate it, funds in India use a standard formula:
Portfolio turnover = Lower of value of purchases (or) sales in the last 12 months/Average assets in the last 12 months.
It is expressed in ‘times’ or percentage. A portfolio turnover of 10% or 0.10 times indicates that the fund has transacted in only a tenth of its holdings by value in the past year. A ratio of 300% or 3 times shows that it has transacted enough to replace the entire portfolio nearly three times over. While the value of purchases or sales may not correspond exactly to the number of stocks that have been replaced, a higher turnover definitely means that the fund manager likes to juggle the scheme’s holdings more, while a low turnover indicates a more buy-and-hold approach.
You should however bear three factors in mind while interpreting portfolio turnover.
- A fund which has received high inflows or outflows in a year may witness a temporary spike in portfolio turnover, because the changing asset size would have led to portfolio churn. Before interpreting high turnover numbers, do check if a funds assets have seen a material change over the year.
- A fund which has a derivatives exposure is likely to have high portfolio turnover because futures and options positions will be closed and re-initiated every month. Equity savings funds, arbitrage funds, balanced advantage funds may have a high portfolio turnover for this reason. Some funds disclose asset-class wise turnover and you can look at this to gauge true turnover. If a fund gives the turnover for derivatives separately you can exclude this while gauging the scheme’s turnover.
- In passive funds, the fund manager has no control over portfolio turnover because his transactions are driven by changes in the underlying index.
Many funds routinely disclose portfolio turnover in their monthly factsheets. Some don’t. In these cases, you can find it in the statutory disclosures. SEBI mandates that all funds must disclose their portfolio turnover along with their monthly and half-yearly scheme portfolios. You can also use the MF Screener (you will find the data under Add Filters -> Portfolio)
How to use it
So, now that you know what portfolio turnover ratio is, how should you, as an investor, use portfolio turnover?
Hidden costs
Brokerage and transaction costs incurred by mutual funds on buying or selling securities are not included in the Total Expense Ratio (TER) of the scheme prescribed by SEBI (do note that returns that you see are net of all expenses). Such expenses are however charged to the scheme over and above the TER and therefore directly dent your returns. SEBI rules allow mutual funds to incur transaction and brokerage costs at 0.12% of trade value for cash market trades and 0.05% for derivative trades. But these limits apply to individual trades.
There is no aggregate limit on the brokerage or transaction costs that can be incurred by scheme for all its transactions. In its consultation paper on TER last year, SEBI had in fact observed that some AMCs were charging more than their allowed TERs as brokerage and transaction costs in their schemes. In effect, schemes with a TER of 1 or 2% were incurring another 1 or 2% towards brokerage and transaction charges. This resulted in investors in these specific schemes paying more than double the allowable TER. This points to the impact that high portfolio turnover is likely to have on a scheme’s NAV and returns.
A fund manager with high portfolio turnover will need to meet a higher bar on returns from his or her stock holdings to compensate for the higher transaction cost, compared to a manager with low turnover.
This is why it is useful to view portfolio turnover data over time in conjunction with a fund’s returns. If a fund with high turnover also manages to outperform, it is an indicator of a successful momentum strategy. If a fund with high turnover underperforms, it could be a sign that the fund manager is getting many of his calls wrong and is in trial-and-error mode.
Transparency
Often when deciding to buy, hold or sell a fund, we check out its latest portfolio. However, funds are required to disclose their portfolios only once a month. So what we get to see is the portfolio as on a specific date at the end of the month. We really cannot gauge what transpired in the portfolio between two month-ends. So, if you are looking at the August 2024 disclosures today, what you see is the portfolio composition as on August 31 2024. You really don’t know what the portfolio was on say August 20 or August 10.
Now, when a fund has low portfolio turnover of say, 0.1 or 0.2 times, it replaces roughly 10% or 20% of its holdings in a year. Therefore, its month-end portfolios are generally a reliable indicator of the stocks and sectors that the fund held through the month. But when a fund reports a portfolio turnover of over 100%, the month-end portfolio may not be indicative of its actual holdings because its holdings change so frequently.
Even if the month-end portfolio is of high quality, the fund could have traded in and out of low-quality stocks, flipped IPOs, punted on derivatives or used other short-term strategies to deliver its returns. In effect, it is easier to gauge how funds with low portfolio turnover make their returns. It is very challenging to gauge how funds with high portfolio turnover are making their returns.
Verifying style and strategy
We have earlier highlighted how important it is for you to know the investing style of the schemes you’re buying. This is not straightforward because fund managers may not always walk the talk on style. Portfolio turnover can be a good indicator of whether a self-proclaimed value manager has a buy-and-hold approach to his stocks. It can also indicate whether a fund is pursuing a momentum strategy without overtly stating it.
PPFAS Flexicap Fund for instance, had a portfolio turnover of just 0.7 times in end-August 2024 excluding its derivative exposure. This suggests that the fund does follow the fundamentals-based buy and hold style that it professes to follow. Quant’s Flexicap Fund had a portfolio turnover of 3.92 times, its Midcap Fund 3.06 times and Large & Midcap 3.43 times. These are indicators of a momentum style of investing (Quant incidentally does not disclose its turnover data in its factsheet).
Comparing turnover numbers within a category can help you choose funds that go well with your preferred style of investing. For instance, Edelweiss Balanced Advantage Fund had a portfolio turnover of 2.09 times in August 2024 (0.80 times on its equity portfolio alone) compared to 0.29 times for ICICI Pru Balanced Advantage Fund. This suggests that Edelweiss is probably relying less on a buy-and-hold strategy in its balanced advantage fund than ICICI Prudential.
Fund manager changes
It goes without saying that a fund’s performance record is the outcome of the sectors and stock choices of its fund manager. When a successful fund manager quits or the fund house shuffles around its managers, investors come to know of the change in their scheme’s strategy or style only when it shows up in their returns.
However, portfolio turnover data can offer you early indicators of such shifts. If a new fund manager taking over the baton from an earlier one, has a materially different style or is replacing a significant proportion of the portfolio, this shows up early on in the monthly portfolio turnover.
For instance, when star fund manager Prashant Jain announced that he was exiting the fund in 2022, HDFC Flexicap – his flagship fund was following a deep value strategy and had underperformed the category in 2 of the previous 3 years. When Roshi Jain took over the reins of the fund in July 2022, there were questions about whether she would follow the same style or replace some of the holdings.
While the fund’s top holdings didn’t change much after this transition, the portfolio turnover data shows that she did make several changes. HDFC Flexicap’s portfolio turnover which hovered in the sub-25% range during Prashant Jain’s tenure rose to nearly 33% by September 2022 and nearly 40% by end of the year. This coincided with the fund sharply outperforming the category and the index.
While the Prashant Jain exit was a widely publicised one, in most cases, exits or changes involving less-known managers fly under the radar. Tracking turnover data from month to month can tip you off to material strategy shifts without having to run over the holdings with a fine-tooth comb. If turnover numbers go beyond 75% levels with or without a manager change, it is in fact a sign of a material change in its very character.
Such high turnover numbers can sometimes invalidate a fund’s past track record, as there’s no guarantee that the new set of stocks will do as well as the earlier set. To be sure that a Dr Jekyll isn’t turning into a Mr Hyde, tracking such a fund’s return and volatility metrics can help you notice a slip-up in performance.
Choosing passive funds
Finally, portfolio turnover data also has a unique application in India. It can help you choose the right kind of passive fund.
In theory, index funds and ETFs are supposed to have low portfolio turnover because the fund manager will churn the portfolio only if there are changes in the underlying index. In India however, index providers have a tendency to over-activity and change the constituents of the indices quite often. This results in index funds frequently churning their portfolios. High churn in index funds leads to high transaction costs and contributes to the index fund or ETF throwing up a high tracking error relative to the underlying index.
Checking out the portfolio turnover ratios of passive funds before buying them, can tell you if the index you’re looking to mirror is prone to high churn. Checking out the portfolio turnover of various passive funds in the Nippon India portfolio shows the following.
This clearly shows that if you go in for the Smallcap250, Midcap150, Alpha Low Volatility or Nifty Next 50, you should expect high tracking error relative to the underlying index.
