How should your equity fund manager run your portfolio? Should he buy stocks and hold on to them? Or should he trade frequently depending on the opportunities that the stock markets throw up? Is active management the road to riches or is a passive approach the way to wealth? Or does it matter?
Well, each buy and sell transaction in the stock markets involves a brokerage cost. This brokerage cost has to be borne by the mutual fund, which in turn passes it on to its investors. So investors have to pay for the trading carried out by the fund on their behalf. Obviously, higher the volume of trading, greater will be the associated costs. And greater trading costs can definitely eat into returns.
So how does one know how much the fund manager is trading? The answer to this question is provided by the turnover ratio. The turnover ratio represents the percentage of a fund's holdings that change every year. To put it simply, a turnover rate of 100 per cent implies that the fund manager has replaced his entire portfolio during the period given.
Technically, the turnover ratio is the lower of the total sales or total purchases over the period divided by the average of the net assets. Higher the turnover ratio, greater is the volume of trading carried out by the fund.
Is a high turnover bad? Well, that depends on what it achieves. If high turnover can generate high returns, then there should be no problems. The problem arises when a fund is trading heavily and not generating commensurate returns.
The turnover ratio is more important for equity and balanced funds where the trading cost of equities is substantial. So, each time a fund manager buys and sells, he has to keep in mind that the cost of buying and selling will eat into the fund's returns. Dynamic equity funds, which can move rapidly between sectors will obviously have a higher turnover ratio. Here risk will not be just of the fund manager making a wrong call on a sector but also that of turnover risk. In comparison a passively managed fund, such as an index fund, will have a lower turnover rate compared to an active fund as it has to just mirror the index. The only trading here will be due to investments, redemptions and changes in the index. Also, it is not meaningful to use turnover ratio for new schemes, which are not fully invested. As the scheme is deploying its assets there will be more transactions, at least buy orders, as compared to a fund` which is fully invested.
Turnover ratio is less relevant for income funds as brokerage costs are much lower, and hence they will have a lower potential to eat into returns. So, even though gilt funds may have equally high turnover as compared to equity funds, the impact of this turnover is much less.
Much of the discussion on turnover ratio originates from the US, were actively managed funds have not performed as well as index funds. The argument is that trading costs of actively managed funds put them at an inherent disadvantage as compared to passively managed funds, which follow a buy and hold approach. However, in India actively managed funds have managed to convincingly beat the index.
Nonetheless, when you look at your equity fund returns, do look at the turnover ratio. If your fund has not generated much returns but has not traded much, you can feel sad. If however, your fund has been merrily trading away without generating returns, you should feel even more unhappy. More importantly, if considerable time has elapsed and this state of affairs continues, then it is time to increase the turnover of this fund in your portfolio.