Mutual Fund Turnover Ratio: Relationship with Returns and Expenses

Selecting a right fund is not an easy task for an investor and he must go through various ratios and definitely calculate returns before zeroing on any fund. One among such ratios is the ‘Turnover Ratio’. It is measured by taking the lower of the total sales or total purchases and dividing it by the average month-end net assets of the scheme. In simple words, it shows how frequently the stocks in the portfolio are bought and sold. It is expressed in percentage terms like 67% or 128%. Therefore, a fund having a turnover ratio of 67% reflects a number of holdings that has been replaced over one year period. Hence, a fund having a turnover ratio of 100% means that all the holdings of the scheme have been replaced in the last one year.

Normally, funds having value approach of investing should have lower turnover ratio as they invest in undervalued stocks and wait till the market recognises the potential of these stocks. This may take some time and, therefore, the churning is less and hence turnover ratio is low. Lower churning involves lower incidence of taxes, brokerages and commission and may be lower expense ratio. On the other hand, growth funds may have higher turnover ratio as the fund manager is constantly looking for the next leaders and keeps on entering and exiting holdings faster than value-oriented funds.

Nonetheless, everything boils down to returns generated by funds. So, the moot question is, does a fund with higher turnover ratio generate higher returns?

We analysed all the equity diversified funds—excluding ETF and index fund—to understand whether there is any relation between turnover ratio and returns. The answer to this question is that there is no significant relation between turnover ratio and returns. Although there is a feeble negative correlation of .008 between both, it is statistically insignificant. Hence, a fund having higher turnover ratio does not mean it will generate higher returns. There are funds that have high turnover, yet their returns are lower than returns on an average fund.

Many a time it is assumed that large-cap funds will have lower turnover ratio and small-cap funds will have higher turnover ratio. If we analyse in terms of capitalisation, that is, large cap, mid-cap and small-cap, we do not find any relation between quantum of capitalisation and turnover ratio (see table below).

One more argument that goes with the turnover ratio is that funds that are churning their holdings more frequently have higher expense ratio due to the costs (brokerage, commission, etc)

associated with trading frequently. Once again, we did not find any direct relationship between turnover ratio and expense ratio, and although it gave us a feeling that there is some positive relationship between expense ratio and turnover ratio, statistically the correlation is insignificant.

From the above discussion, we find that turnover ratio does not give any insight into picking the right equity fund. Nevertheless, if a fund in your portfolio has a higher turnover ratio and is not generating commensurate returns, you should reconsider continuation of this fund in your portfolio.