When churn is sky-high

All MF investors want their funds to be actively managed. But what if it becomes hyperactive? Like hyper activity in your kid, too much churn in your fund portfolio may be a bad sign.

Portfolio turnover is the key statistical ratio used by smart investors to assess the extent to which the manager churns the portfolio. Industry body AMFI mandates that fund houses calculate portfolio turnover by taking the lower of purchases and sales on each day and then dividing it by average net assets. When this number is higher than usual, you know something is not right.

An analysis of portfolio turnovers across equity fund categories shows a few funds sporting turnovers over 100% to nearly 700%. Speaking to Value Research, top MF industry officials came up with different reasons including abnormal flows, fund mergers, and portfolio construction to explain this.

Going by the thumb-rule, higher the turnover ratio, greater is the volume of trading carried out by the fund. Higher the volume of trading, greater will be the associated costs. Greater trading costs definitely eat into returns. Moreover they may signal that the fund manager is chasing momentum or getting his calls wrong, to require frequent replacement. This is the reason why portfolio turnovers merit attention.

IDFC MF's Sensex ETF and Nifty ETF sport portfolio turnovers of nearly 700%. That's unusual in a supposedly passive index fund. But the numbers shouldn't alarm you, if you go by the explanation. What has bloated up the portfolio turnover in this case is fluctuation in the denominator - the average assets of the scheme. According to industry sources, both the funds are new schemes (launched in Sep-2016) and sponsor of the AMC had contributed a lion's share of assets during the NFO. As and when the sponsor took out the money post-NFO, this brought down assets and heavily impacted the portfolio turnover ratio, sources added. The two IDFC funds fall under large-cap category, which interestingly has quite a few ETF/index funds that have extremely low portfolio turnovers of 2-5%.

Banking equity funds have been darlings of investors, with one-year category average return of 40% plus. However, there are many funds in this sectoral space that have high portfolio turnovers. The one that takes the cake is Kotak PSU Bank ETF, which sports a portfolio turnover of 358.87%. Ordinarily, an exchange traded fund is supposed to just track an index and not make too many portfolio changes right? So, what is Kotak PSU Bank ETF doing to get that extremely high turnover?

Deepak R. Gupta, Fund Manager, Kotak Mutual Fund explains that the figure is high because of the formula for calculation of portfolio turnover. "The formula states that we have to take the lower of purchases and sales on each day and divide it by average net assets. In case of Kotak PSU Bank ETF, the corpus almost tripled albeit from a low base and then became almost 1/10th of the peak corpus reached during the year. This led to big purchases and sales in the fund. The average AUM for the year turned out to be very low. This has magnified the portfolio turnover."

Kotak MF's Gupta elaborates that theoretically, while calculating the portfolio turnover, any purchase or sale of securities necessitated by the inflows/ outflows by the investors from the fund should ideally be ignored. "But since the formula mandated by AMFI does not make any such provision, the figure gets inflated during times when heavy inflows as well as outflows happen during the same period in the same fund. In simpler words, there were huge inflows and outflows in the fund during the period. AMFI's formula for calculating the portfolio turnover ratio does not account for that i.e. it does not exclude purchases and sales of securities necessitated by the investors coming in and going out of the fund," he adds.

In the infrastructure funds space, there are funds that have 5-24% portfolio turnover, and also funds that sport high portfolio turnovers of over 100%. Taurus Infrastructure Fund (156%), Reliance ETF Infra BeES (132%), ICICI Prudential Infrastructure Fund (125%) and BOI AXA Manufacturing & Infrastructure Fund (114%) are some examples. Reliance ETF Infra BeES is an interesting case since this is the only passive fund in the pack and yet has one of the highest portfolio turnovers. A Reliance MF spokesperson reiterated that since Reliance ETF Infra BeES is a passive strategy fund which tracks the index, there is no active stock picking by the fund manager of the scheme leading to high portfolio turnover. "The high portfolio turnover is due to new subscriptions/redemptions in the fund in which case the fund manager of the scheme has to either purchase or sell the underlying securities in the same proportion so as to track the weightage of the underlying securities in the index," the company spokesperson elaborated.

The high portfolio turnover, according to Reliance MF, does not impact investors by way of costs. "...all the cost related to purchase or sale of the underlying index securities is charged to the investor directly subscribing or redeeming to the units of Reliance ETF Infra BeES and hence zero cost is charged to the scheme, not impacting the existing unit holders in the fund. Whereas in case of any actively managed scheme, the cost of purchase or sale securities is borne by the scheme ultimately impacting the returns of all the unit holders of the scheme irrespective of the investor following the buy and hold strategy," the spokesperson argued.

Fund manager changes can also necessitate portfolio churn, because a new manager will like to build a portfolio according to his wishes. The mid-cap equity fund segment is a keenly tracked space, because it has witnessed great wealth generation for investors. Of late, there have been cases where fund managers have expressed concerns about valuations and also lack of investible opportunities. There are quite a few funds in midcap category that have portfolio turnovers in excess of 200% like Baroda Pioneer Midcap Fund, DHFL Pramerica Midcap Opportunities Fund, and Taurus Discovery Fund. DHFL Pramerica Midcap Opportunities Fund (247% in Feb-end) is among those funds that has seen fund manager changes.

"In the last 1 year, there have been fund manager changes for the DHFL Pramerica Midcap Opportunities Fund. As a result, there were changes made to the portfolio during this time frame. This has resulted in high turnover for the find. Going forward, we expect this ratio to come down in the next six months or so. We have already seen it come down to 210% in end of March 2017 from 247% in end Feb 2017," the DHFL Pramerica spokesperson noted.

Some funds have admittedly had to face higher portfolio turnover because they have had to construct portfolios differently due to mergers. A notable example is Edelweiss Top 100 fund (354%). Edelweiss CEO Radhika Gupta explains: "JP Morgan India Top 100 Fund was merged with Edelweiss Top 100 Fund recently. This led to portfolio changes, bumping up the portfolio turnover. The ratio is expected to normalise."

Another example of portfolio rejig leading to high turnover is DHFL Pramerica Tax Savings Fund (268%), the highest for any tax-saving fund. A DHFL Pramerica spokesperson said: "The DHFL Pramerica Tax Savings Fund was launched in mid Dec 2015 and since then the fund has grown AUM 3 times from Rs 32 crore to Rs 93 crore at end of Mar 2017. The portfolio has been under construction during this period, as a result the fund has seen a high portfolio turnover ratio. However we should see improvements in this ratio, going forward."