Portfolio Turnover Ratio & MF Returns

Investors take different routes to select mutual funds. Most of them look at historical returns to gauge future performance. Many compare this return with their peers and benchmark to arrive at an investing decision. Some risk-aversive investors also look at risk measures to understand the risk and commit funds if it meets their risk profile. However, a lesser-known but equally significant metric is the Portfolio Turnover Ratio (PTR). This article delves into what the portfolio turnover ratio is, how it impacts mutual fund returns, and should investors be caring about it [EasyDNNnews:PaidContentStart]

The Portfolio Turnover Ratio (PTR) is a metric that indicates the percentage of a mutual fund’s holdings that are replaced during a specific period, typically a year. Simply put, it reflects the level of trading activity within the fund’s portfolio. For example, if a mutual fund has an average asset under management (AUM) of ₹500 crore and buys or sells securities worth ₹100 crore during the year, its PTR would be 20 per cent. It’s important to note that the costs associated with portfolio turnover are not included in the fund’s expense ratio.

While the expense ratio covers management fees, administrative costs, and other operational expenses, it does not account for the transaction costs incurred from buying and selling securities. These additional costs, arising from portfolio turnover, can affect the fund’s overall performance. Therefore, investors should consider both the expense ratio and the potential portfolio turnover costs when evaluating mutual funds. Many investors tend to forget this inclusion or bypass it while focusing only on the returns. That’s a big mistake!

Portfolio Turnover Ratio and One-Year Returns
To assess whether the Portfolio Turnover Ratio significantly impacts mutual fund performance, we analysed the correlation between the PTR and one-year returns of equity-focused mutual funds that have completed at least one year. The analysis revealed a correlation coefficient of -0.114, indicating a weak negative relationship between portfolio turnover and one-year returns.

This suggests a slight tendency for higher portfolio turnover to correspond with marginally lower returns, though the relationship is not strong enough to serve as a decisive factor in fund selection. The low magnitude of this correlation underscores that other factors are likely play a more significant role in influencing mutual fund returns. Consequently, while PTR can offer insights into a fund’s trading strategy, it should not be viewed as a standalone predictor of performance.

Regression Analysis: Portfolio Turnover Ratio and Returns
To delve deeper into the relationship between Portfolio Turnover Ratio and one-year returns, we conducted a regression analysis. The results further highlight the limited impact of PTR on returns. The analysis yielded a slope of -0.0102, indicating that for every 1 per cent increase in portfolio turnover, the returns decrease by only 0.0102 per cent. The intercept of 14.47 suggests that if the portfolio turnover were zero, the expected return would be approximately 14.47 per cent.

However, this intercept is theoretical and specific to the sample data used. The p-value of 0.0038 is statistically significant at conventional levels, suggesting that the observed relationship is unlikely to be due to chance. Despite the statistical significance, the magnitude of the effect is minimal, reinforcing that portfolio turnover alone is not a strong predictor of mutual fund returns. This analysis underscores the need to consider other factors in conjunction with PTR when evaluating mutual fund performance.

The analysis above includes the entire category of equity funds, encompassing index funds and thematic funds, where portfolio turnover can vary significantly due to their inherent structure. For instance, Large-Cap or index funds typically involve minimal portfolio changes by the fund manager, whereas arbitrage funds often experience substantial churning. To account for these differences, we refined the analysis by focusing only on fund categories with more than 25 funds and conducted a separate regression analysis. Other than flexi-cap funds and the ELSS category, we could not find other category of funds where PTR plays an important role in determining the one-year return. The impact of PTR remains below less than 1 per cent in their one-year returns. Hence, for all practical purposes, we do not see the PTR impact on returns of the funds in a year.

Categories of Portfolio Turnover Ratio
Let’s examine PTR across various fund categories. For this analysis, we considered only those categories with at least 15 funds. The box plot below highlights category-wise PTR, revealing some key patterns:

1. Thematic Funds : Thematic funds exhibit the highest turnover ratios on a median basis. Many thematic funds have turnover ratios exceeding 80, with some as high as 81, 107, 498, and even 547. These funds are designed to focus on specific sectors or investment themes, and their higher turnover reflects the need for active management in response to changing market trends and sector dynamics. This frequent buying and selling of assets aligns with their active management approach.
2. Large and Mid-Cap Funds : Large and mid-cap funds tend to show moderate to high turnover ratios, ranging between 46 and 139.
3. Large-Cap Funds : Large-cap funds generally have lower turnover ratios compared to thematic and flexi-cap funds, often reflecting a more passive, buy-and-hold strategy. Most large-cap funds have turnover ratios ranging from 1 to 75, with several funds reporting single-digit turnover ratios, such as 1, 3, 5, 7 and 12. This aligns with their focus on stable, well-established companies.
4. International Funds : International funds also tend to exhibit lower turnover ratios, reflecting their more passive management styles.

Key Observations
The data aligns with expectations:
n Thematic funds generally have higher turnover ratios due to their active management approach.
n Large-cap funds tend to maintain lower turnover ratios, indicative of a more passive investment strategy.

No Clear Link Between PTR and Returns
As discussed earlier, there is no evident direct correlation between a fund’s turnover ratio and its returns. This reinforces the idea that PTR alone is not a definitive factor in determining a fund’s performance.

Portfolio Turnover Ratio Across Fund Houses
The box plot of PTR by fund house highlights that Quant Mutual Fund has the highest PTR among its peers. On an average, Quant Mutual Fund records a PTR of 290, with a range spanning from 79 to an astonishing 498. Quant Mutual Fund is well-known for its dynamic investment strategy, characterised by high portfolio turnover. This approach involves frequent buying and selling of stocks to seize market opportunities. For example, the Quant Quantamental Fund reports a turnover rate of approximately 500 per cent, meaning its portfolio was completely churned five times within a single year.

The fund employs a VLRT methodology (valuation, liquidity, risk and timing), which allows it to remain sector-agnostic and adapt quickly to market shifts. This dynamic strategy often results in significant portfolio churning, as fund managers continuously rebalance holdings to align with evolving market conditions. While high turnover ratios have historically contributed to strong returns for Quant Mutual Fund, the latest performance has not inspired the same level of confidence. Other fund houses, such as LIC Mutual Fund and Bandhan Mutual Fund, exhibit a considerable range in their portfolio turnover ratios, reflecting varying investment strategies across different funds.

The AMC that has shown lowest PTR on average is UTI Asset Management Company (UTI AMC). The fund house’s relatively lower portfolio turnover ratio can be attributed to its emphasis on building long-term portfolios of high-quality businesses, often referred to as ‘compounders’, which exhibit strong franchise durability, high cash flow generation, low capital intensity, and minimal financial leverage. This focus on long-term investments naturally results in fewer transactions within the portfolio, leading to a lower turnover ratio.

Analysing PTR: Key Considerations for Investors
1. Consistency with Fund Objectives: Ensure the turnover ratio aligns with the fund’s stated objective. For instance, a Small-Cap fund with a very low PTR might signal passive management, which could be a red flag.
2. Historical PTR Trends: Look at how the PTR has evolved over time. A sudden spike could indicate a shift in strategy, possibly due to a new fund manager or market conditions.
3. Comparative Analysis: Compare the PTR of a fund with its peers in the same category. A significantly higher or lower ratio might warrant a deeper look.
4. Impact on Expense Ratio: Funds with higher PTR often have higher expense ratios, which directly affect returns. Investors should evaluate whether the additional costs are justified by performance.

Should Portfolio Turnover Be a Key Factor in Investment Decisions?
While portfolio turnover can provide insights into a fund manager’s investment style—whether they adopt a highturnover strategy (frequent trading) or a low-turnover approach (buy-and-hold)—it should not be the sole criterion for investment decisions. Investors should consider portfolio turnover as one of many factors, alongside expense ratios, fund manager performance, historical returns, and alignment with their investment goals and risk tolerance. Portfolio turnover offers context but is not sufficient on its own to predict mutual fund performance.

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