When you are investing in a mutual fund, it is important for you to remember that the fund manager follows his own style of handling your portfolio.
In certain cases, the fund manager tends to buy stocks and hold onto them for a long time and only sells them if certain situations so demand.
But in other cases, the fund manager keeps on buying and selling the stocks that his fund holds. The question that arises: why does the fund manager do so and how does it impact the fund's returns?
In order to answer these questions, you need to understand turnover ratio. This is important as each time the fund buys and sells the stocks, he incurs brokerage expenses. In turn, these expenses are passed on to the mutual fund and ultimately to the investors. So while investing, it is important for you to keep a watch on this ratio.
- Definition of turnover: In simple terms, buying and selling of stocks in the portfolio is known as turnover. Higher turnover may lead to higher returns but again these returns need not justify the higher costs associated with the transaction. As the costs go up, the returns go down. E.g. if the returns generated by turnover are 15 per cent and the costs involved are 12 per cent, then you actual earn 3 per cent.
- Turnover ratio the key to understanding your fund: Want to find out the approach adopted by your fund manager to handle the fund's portfolio? Then find out the fund's portfolio ratio. It denotes the percentage of the holdings of the funds that changes each year. So if a fund has a turnover ratio of 60 per cent, means 60 per cent of the fund's portfolio changes each year. It is calculated as lesser of total sales or total sales for the given period / the average of the net assets of the fund. Higher turnover ratio implies higher the volume of trading performed by the fund.
- Importance of turnover ratio for equity funds: Do you think high turnover ratio is bad? It may not be so if the fund can manage to give high returns.
But if the returns cannot justify the high ratio, then such a fund has to be avoided. In the funds, where equities are involved, these trading costs can be quite significant.
As these costs go up, the fund's returns are affected significantly. Funds like flexicap funds, where the fund manager has the mandate to switch between the companies of different market capitalisations, have higher turnover ratio.
The danger here is that when choosing the company to buy or sell, he fund manager can take a wrong call.
This can dramatically affect the fund's returns. On the other hand, index funds are not much affected by the turnover ratio as the fund manage buys and sells only if there is change in the index composition, redemptions and any new investments in the fund.
Moreover this ratio is not applicable to new funds as the fund has yet to deploy its funds fully.
With regards to the income funds, the brokerage costs are lower than the equity funds, the effect of this turnover is not as severe as its effect on the equity funds.
It is due to this ratio, index funds have become popular in India, as the opponents of active fund management principle say that it is quite difficult to outperform the index each time, as the fund manager can err in his decisions. But in India, the actively managed funds have managed to outperform the index.
As an investor, you should be concerned about the way in which the fund manager manages your fund.
If he buys and sells the stocks in the fund regularly, you end up paying more and thus reducing your returns. While this strategy can give you high returns, it is more likely that the fund manager may make wrong choice.
So always watch out for the turnover ratio when choosing the fund. Certain funds have higher turnover ratio than others. Find out if the turnover has managed to give significant returns. Otherwise it is time you dump the fund.