Portfolio Turnover Ratio

Every time a fund manager buys or sells a security, the scheme pays broking costs. A manager who churns the portfolio constantly is spending unitholders' money on transactions and, the workbook adds, may be showing signs of unsteady investment management.

The portfolio turnover ratio measures that churn. Take the value of securities bought during a period and the value sold, pick whichever is lower, and divide by the scheme's average net assets over the period.

Why the lower of the two? Because money flowing in from new investors forces purchases, and redemptions force sales, whatever the manager thinks. Using the smaller figure isolates the trading the manager chose to do.

The ratio translates neatly into a holding period. A turnover of 1 (100 per cent) implies securities are held about a year on average; a turnover of 2 implies about six months.

The workbook's illustration: purchase and sale transactions for a year of Rs 10,000 crore, and average net assets of Rs 5,000 crore.

Portfolio turnover ratio = 10,000 ÷ 5,000 = 2, or 200%
Average holding period   = 12 months ÷ 2  = 6 months

Whether that is good or bad depends entirely on the investment style:

Turnover has a direct cost. The TER rules allow brokerage and transaction cost for executing trades of up to 0.06 per cent of trade value in the cash market and 0.02 per cent in derivatives, on top of the base expense ratio. The more a scheme trades, the more of that allowance it uses.

The same phrase appears in Chapter 6 in a different sense. AMCs must disclose distributor-wise data, and where it shows a distributor has an excessive portfolio turnover ratio — more than two times the industry average — the AMC must conduct additional due diligence on that distributor. There, the churn being examined is of investors' holdings by the distributor, not of the scheme's securities by the fund manager.

Portfolio Turnover Ratio
  = Lower of (Value of purchases, Value of sales) during the period
    ÷ Average net assets during the period

Average holding period (months) ≈ 12 ÷ annual turnover ratio

Two equity schemes, each with average net assets of Rs 6,000 crore over a year. Figures are illustrative.

Scheme P's 20-month holding fits a value approach. Scheme Q's 6 months fits momentum, but would be a red flag if Q called itself a value fund.

Now the cost. At the 0.06 per cent cap on cash-market trade value, Scheme P's total trading of Rs 7,800 crore could carry up to Rs 4.68 crore of brokerage and transaction cost — about 0.08 per cent of its net assets. Scheme Q's Rs 25,200 crore of trading could carry up to Rs 15.12 crore, about 0.25 per cent.

For an investor with Rs 10 lakh in each, that is roughly Rs 800 a year in P against Rs 2,520 a year in Q, charged inside the NAV, before a rupee of base expense ratio.

Chapter 12 (Mutual Fund Scheme Selection), section 12.4, defines the ratio with the Rs 10,000 crore / Rs 5,000 crore example and ties it to investment style; Chapter 6, section 6.6, uses "excessive portfolio turnover ratio" for distributors; Chapter 7 gives the brokerage caps. Expect a computation of the ratio or the implied holding period, and a question on how turnover should be interpreted relative to style.

• Use the lower of purchases or sales, not their sum and not the higher.
• Divide by average net assets over the period, not closing net assets.
• Turnover of 2 means about 6 months' average holding, not 2 years.
• High turnover is not automatically bad. It must be read against the investment style.
• Frequent churning adds broking costs and may indicate unsteady investment management.
• The distributor rule is different: a distributor whose portfolio turnover ratio exceeds two times the industry average triggers additional due diligence by the AMC.