Making sense of portfolio turnover in mutual funds

Any fund manager overseeing a mutual fund will constantly be churning their portfolio to get rid of underperformers, take profits on stocks, buy potential bets, rebalance holdings or align to a specific strategy. But portfolio turnover can increase costs for investors due to the periodic buying and selling. There is also a concern about why a fund manager sometimes churns too much or too little. Here’s why investors must keep tabs on a fund’s churn, measured by the portfolio turnover ratio.

Measuring churn

The portfolio turnover ratio indicates the frequency of changes made in the fund manager’s portfolio. The lower amount of stocks bought or sold in a year, divided by the average assets under management (AUM), gives the turnover ratio. Let’s say a fund bought stocks worth ₹1,000 crore in 2022, and sold to the tune of ₹1,200 crore. If its average AUM during 2022 is ₹10,000 crore, the portfolio turnover ratio is 0.1 or 10 per cent. You can get the portfolio turnover ratio of a particular scheme from its factsheet.

A fund’s turnover ratio may also be affected by the inflows/outflows of corpus from investors and usage of the derivatives.

Portfolio turnover across schemes

The portfolio turnover ratio should generally be used for actively managed equity oriented-schemes. In the case of debt funds, depending on inflation and interest rate movements, modest churn happens.

As per Value Research data, for large-cap active MF space, the average portfolio turnover is 48 per cent. Of 30 large cap actively traded mutual funds, about 27 per cent of MFs have a ratio ranging from 10-30 per cent, where the lowest being for funds such as IDBI India Top 100 Equity Fund (12 per cent), SBI Bluechip Fund (13 per cent) and Kotak Bluechip Fund (14 per cent). Five funds. i.e. about 17 per cent of funds in the space have it higher than 80 per cent, which includes funds such as Quant Large Cap Fund (118 per cent), Mahindra Manulife Large Cap Fund (106 per cent) and Taurus Large Cap Equity Fund (97 per cent).

For mid-cap space, five out of 25 funds have a ratio of more than 80 per cent, including the Mahindra’s (138 per cent), Taurus’s (127 per cent) and Motilal Oswal’s (100 per cent) funds. Eleven funds have portfolio turnover of up to 30 per cent, which includes Kotak’s (2.87 per cent), JM’s (4.69 per cent) and IDBI’s (7 per cent) funds. The average portfolio turnover has been 49 per cent for the category in last year.

In the small-cap space, of the 25 funds, 13 have a ratio of less than 30 per cent, including funds such as Tata Small Cap Fund (5.7 per cent), Canara Robeco Small Cap Fund (6 per cent) and Axis Small Cap Fund (6 per cent) while only two PGIM Small Cap Fund and Union Small Cap Fund have the same over 100 per cent. Here, the average turnover for the category has been around 30 per cent.

Could churn lead to better returns?

There have been funds such as Quant Midcap fund, the best performer of the category by generating a CAGR return of about 37 per cent in the last three years with a turnover of over 100 per cent consistently. On the other hand, the funds such as SBI Blue Chip, one of the best-performing funds in the category, generated a CAGR return of about 20 per cent during the period, with turnover as low as around 15-20 per cent. Hence there is no proven correlation between turnover and returns.

However, it can be implied that a fund manager who can generate above-average returns with lesser turnover might have a conviction in his strategy. Further, though high portfolio turnover might not guarantee returns above the category average, it is expected to do so due to the cost involved. Every time a mutual fund buys and sells securities, it incurs costs such as brokerage and security transaction tax. Hence, it is expected that if a fund manager is involved in higher trading activity, the mutual fund is expected to generate high-risk adjusted returns to compensate for such costs.

Ultimately, the portfolio turnover ratio can be considered a key factor while analysing mutual funds and understanding a fund manager’s strategy. However, investment decisions should not be made solely based on the portfolio turnover and investors also need to look at other metrics too. 

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