A reader asks, “How important is turnover ratio in choosing a mutual fund? While selecting an index fund, should Turnover ratio be considered?”
The portfolio turnover ratio is the lower of the total of new stocks purchased or sold over 12 months, divided by the fund’s average assets under management (AUM).
For example if a fund sold Rs. 1000 Crores of stocks and purchased Rs. 1200 Crores of stocks over the last 12 months when its average AUM was Rs. 11,000 Crores, the turnover is minimum of total sold and told bough divided by average AUM. That is, 1000/11000 = 9%.
There are only two things we know for sure about the turnover ratio:
- Higher the turnover or churn more is the brokerage costs reducing the fund returns. So high turnover without a high margin of outperformance wrt the benchmark is of little value to the investor.
- Lower the AUM, the higher the freedom to churn. For example, see Mutual Fund Size vs Performance: A Case Study. A fund with a high turnover typically has low AUM (wrt category peers). If this churn results in good outperformance, the fund becomes popular, and its AUM swells. This corresponds to lower and lower turnover and outperformance.. This happened to Prashant Jains funds – HDFC Top 200 and HDFC Equity (now known as HDFC Top 100 and HDCFC Flexicap, see link above) after 2008 crash and recovery, and I suspect it is the fate awaiting the popular funds from Quant.
So, how important is turnover ratio in choosing a mutual fund? A fund with a consistently high turnover ratio month after month, year after year, is typically a young fund chasing momentum. Its immediate reward is possibly high, but if we look at recent performance and invest, we could be disappointed in the future.
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A fund with occasionally high churn, typically corresponding to bull or bear markets, is relative better but will be subject to same extent of fund manager risk as fund with low churn.
How about an index fund? Should one consider the turnover ratio for them? Ideally the turnover ratio of an index should be the same as that of the index. If the fund’s turnover is significantly higher than that of the index or category peers (those tracking the same index), it is a red flag signalling poor management. Alternatively, the tracking error and tracking difference can be used to screen index funds.