Compare turnover ratios before investing in mutual funds
One of the technical parameters for picking up a mutual fund is the cost incurred by the fund. It reflects the costs to achieve the generated return. Of course, one shouldn’t alone be fixated on this one factor as the most importance should be given on the fund objective and the risk profile of the fund. It should match with the investor’s risk appetite and the timelines. But, once this fundamental filter is done then the other factors to be considered is the cost of managing this portfolio.
An important ingredient of cost is the turnover ratio of the fund. A turnover ratio is calculated by taking either the total amount of new securities purchased, or the amount of securities sold whichever is less over a particular period, divided by the total net asset value (NAV) of the fund.
A higher turnover ratio depicts that huge amounts of transactions i.e. purchases and/or sale of securities in the fund happened. For instance, a 100 per cent turnover ratio doesn’t necessarily relate to the entire portfolio of securities during the period to have changed or traded, it could be a sign of higher number of transactions.
One shouldn’t conclude purely from this parameter but also should analyse why this higher turnover took place at the first place. It could reflect the fund objective also. An aggressive and actively managed fund would naturally present a higher turnover while a buy-and-hold strategy employed by a fund would indicate a lower turnover ratio. It’s also certain that due to a higher churn or turnover the costs incurred are high for a fund, which would spike the cost to return.
Not all turnover amounts to high churn of the existing portfolio but any increase or decrease in the fund i.e. higher inflows or outflows could lead to higher transactions and so a higher portfolio turnover. Recently, in a published report, there are funds which had over 750 per cent as a turnover ratio. This was particularly stark with a fund where the fund size has reduced by about a third of its original size.
This sudden reduction in the assets has caused for an aberration but there were about 50 funds from various fund houses with a turnover ratio beyond 100 per cent. This could be also due to the categorisation of the funds announced by the Sebi which mandated to redraw or merge and even collapse a fund to fit into the defined guidelines.
Volatility in the current markets also added for the funds to realign and reallocate securities in their portfolios leading to higher turnovers. Some equity funds or defined equity funds added a flavour of derivatives to arrest the volatility which also amounted for a higher turnover. ETFs and index funds generally have lower turnover ratios as the transactions are very limited with the securities to be dealt is limited.
Same is the case with thematic or sectoral funds where the portfolios are limited to a particular theme and sector and hence a smaller universe to choose from. The other category of funds following a value strategy would also depict a relatively lower turnover ratios due to their style of buy and hold of the securities.
Despite their nature of buying at low (of a particular security) when the overall market ignores (when the valuations are down) and selling after a period with the valuations reaching highs, these funds could sport higher turnover ratios if the fund attracts higher influx of funds.
One shouldn’t hence blindly fix to the turnover ratio while opting for a cheaper managed fund but do compare it across the peer group or category to get a sense of how the fund is sticking to the defined objective. And if a fund is able to generate higher alpha consistently at a higher cost it still could be considered to be invested though a lower performance would add woes to the incremental returns. (The author is co-founder of “Wealocity”, a wealth management firm and could be reached at firstname.lastname@example.org)