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The portfolio turnover ratio at any point in time shows how often the fund has bought and sold stocks in its portfolio in the past one year. A higher ratio suggests more buying and selling in the portfolio, while a lower ratio implies that the fund's trading activity has been low. A turnover ratio of 100% loosely implies that the entire portfolio has been churned once during this period.
A higher churn is a given in funds which follow a `dynamic' investment style--where the mandate dictates that the fund manager calibrate cash exposure more aggressively compared to traditional equity funds. For others, however, the turnover ratio is indicative of the fund manager's investment style, and not an assigned mandate.
How does turnover impact returns?
A fund's turnover reflects the fund house's culture, says Vidya Bala, Head of Mutual Fund Research, Fundsindia.com. "A fund house that doesn't constantly aim to be a table-topper will follow a steadier buy-andhold approach in its portfolio. Others will look to churn constantly in an attempt to chase momentum and stay at the top of the charts," says Bala. So which is the better approach to investing?
Analysed the portfolio churn of equity funds over the past three and five years to understand how it has impacted a fund's performance. Funds with a turnover ratio of more than 100% have been categorised as high-churn funds and those with a turnover ratio less than 50% as low-churn funds. The study is based on open-ended equity diversified schemes which have been in existence for the past five years. Our analysis reveals that, across all categories of funds, low-churn funds have delivered higher returns. Over the past three years, high-churn large-cap funds have delivered 21.5%, while low-churn funds have clocked 22.5%. Over a five-year period, low-churn funds in the large-cap segment have delivered 12.8% compared to 11.6% by high-churn funds. The same trend is visible in the midand multicap fund categories. The multi-cap funds with high churn have delivered 23.9% and 11.8% over the past three and five years respectively compared to 25% and 13.6% generated by low-churn funds. Some analysts attribute the difference in returns to the hidden expense that accompany higher churn.The more frequently a fund trades securities, the higher the associated transaction costs--they keep adding up. These costs eat into the fund's returns. Frequent rotating of stocks, arguably, also suggests that the fund manager lacks conviction in her stock picks.However, this does not necessarily suggest that high churn is always a bad sign, or that low churn will always yield better results.
Go by performance
A buy-andhold approach works best in a trending market. But in a range-bound market, a higher degree of churn would be more suitable," he says. Some fund managers play a rangebound market better while others make the most of a trending market. Besides, level of churn should also be viewed from the perspective of the fund's size: As a fund grows in size, its churn is bound to come down. It doesn't necessarily reflect on the fund manager's investing style. For instance, large schemes from Franklin Templeton, ICICI Prudential and HDFC mutual fund have recorded the lowest turnover in the past few years.
Data shows that there are outperformers among the high-churn funds as well. And so, investors should not shun these funds simply because their portfolio turnover is high. Consistency in performance should ultimately guide your investment decision.
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