What does turnover ratio say about mutual funds?

Calculation: The formula for computing turnover ratio is the minimum of stocks bought or sold, divided by the month-end assets under management of the fund. A turnover ratio of 100% basically means that the fund manager has completely changed the portfolio in the past one year. It also signifies the average holding period of stocks in the fund’s portfolio.

A fund with 100% turnover ratio means that the average holding period is one year, while 300% would mean the average holding period is four months. Different fund houses calculate it differently. Some give the turnover ratio of the overall portfolio, including cash, debt equity or other asset the fund may be invested in, while some only give the turnover ratio of the equity portfolio. Some may give both the numbers. The two numbers can be very different from each other. Therefore, it is important to read the documentation carefully while comparing the turnover ratio of two funds.

Indication: The turnover ratio tells about the investment strategy of the fund manager. Different funds have different investment strategies. Some follow a buy-and-hold strategy, while others actively churn the portfolio to profit from booking gains. In some cases, the fund manager may sell existing stocks and invest in completely new companies or in the same stocks at a lower price. Therefore, it is important to look at the turnover ratio of the fund to understand the investment strategy of the fund manager.

“Higher turnover ratios often indicate higher churn in the portfolio compared with long-term buy-and-hold strategies. A significantly high turnover could also indicate an inconsistent process. This could affect overall returns of the fund over the long term," said Kavitha Krishnan, senior analyst, manager research, Morningstar India.

Cost: A higher churn in the portfolio may have some bearing on the returns of the fund as it will have to pay brokerage and securities transaction tax (STT), which will be passed on to the investors. But brokerage charges have come down over time, and the impact may be less compared to earlier. “Brokerage costs have come down over time, to about 8-10 paisa per 100, while it used to be about 25 paisa,"said Srinivas Rao Ravuri, chief investment officer, equities, PGIM India Mutual Fund. The STT on equity share delivery is 0.1% of the share value, while intraday it is 0.025% (seller pays).

Relevance: If a fund is able to deliver better than peers, high turnover ratio should not be a problem for the investor. “If a fund manager is able to deliver higher returns with a high turnover ratio, then why not? If we look at the turnover ratios of the best and the worst performing flexi-cap equity funds of India, there is a huge difference, but that difference is more than compensated by the much higher returns by the best-performing fund," said Dhiraj Mittal, chartered accountant, certified financial planner and chief executive officer, Prime Capital Services Pvt. Ltd, an investment advisory firm.

Turnover ratio of the fund should not be looked at in isolation. It should not be the criterion to select or reject a fund. But it does offer a peek into the investment strategy of the fund. One should look at the returns and other parameters along with turnover ratio while selecting the fund.