Investors may opt for a buy and hold strategy, or may be active in trading based on the opportunities the markets provide. While this is simple for stock investors to decide on the strategy as they can trade themselves, mutual fund investors need to rely on the fund managers. However, mutual fund investors need not lose heart, as a look at the portfolio turnover would indicate part of the strategy the fund manager is following for the respective fund.
Investors looking for active trading would prefer funds with high portfolio turnover or turnover ratio. Obviously then, a buy-and-hold strategy investor would look for funds that offer a lower turnover.
This is because the portfolio turnover is the measure of how often a fund buys and sells assets. It is generally calculated after considering the total amount of securities sold or bought (whichever is lower) over a fixed period and then divided by total net asset value. Usually, the turnover is calculated for a 12-month period.
The turnover ratio is therefore simply the ratio of the rate of turnover. A turnover ratio of 500% implies the fund manager has replaced all holdings in a portfolio five times in a year. Again, trading half of the holdings ten times in a year would also give us a turnover ratio of 500%.
Good or Bad?
Most importantly, high or low turnover ratio is never an indicator of the fund’s performance. High turnover ratio does not necessarily mean more profits or it does not assure high returns going forward. Similarly, low turnover ratio is not a litmus test for guessing a fund’s performance.
Nonetheless, it serves the purpose of understanding the trading strategy, which is crucial for investors. Morningstar notes that turnover figure between 20% and 30% reflects a buy-and-hold strategy. Turnover above 100% on the other hand reflect high buying and selling activity.
It also helps the cost-conscious fund investors, as every transaction would carry charges. Buying or selling securities carry various expenses, including the taxes made on capital gains. Thus, the good and bad aspect also involves the related costs that the fund will have to bear.
The Cost Factor
Every transaction will come at a cost, which eventually is passed on to the investors. So very high trading activity, or high turnover ratio, may be bad if the high expense ratio dampens the total return.
