Next time, when you invest in mutual funds, do make sure that you understand the company?s portfolio turnover ratios (PTRs) as higher the ratio, the lower will be the returns from the portfolio. In MFs, equity funds diversify their holdings to mitigate risk. Each fund invests in more than 20 stocks to reduce the risk and benefit from performance across segments.
But like any investor, even MFs churn their portfolio to weed out bad stocks from their portfolio or exit from the fund, which has reached its target. An investor must check which asset management companies? an MF is investing in. He should also see how old the fund has performed, its expense ratio and who manages the funds. And, one also needs to keep an eye on the PTR.
PTR numerically measures the trading activity in a fund?s portfolio. The PTR is a percentage of the portfolio that is bought and sold in exchange for other stocks. The portfolio turnover is calculated by looking at the amount of new securities purchased and the amount of securities sold over a particular period. Whichever amount is less gets divided by the average net assets of the fund, giving the PTR. If the portfolio is churned many times during a year, the fund will incur higher transaction costs. If the fund manager has chosen superior stocks that gives alpha returns after considering all the transaction costs, it?s fine. However, if the fund is churning less and generating similar or higher returns, the former would seem unattractive.
Larger PTR will increase the expenses while churning. When the fund?s expenses increase, it, in turn, reduces the returns or yields of the fund. It might seem fine compared with equity funds where you will earn around 15% if you are investing for a long period and pay around 1.5-2% on expense ratio.
But this is not viable in case of debt funds. The PTR and expense ratio are very critical parameters while selecting a debt fund. In debt funds, if you have a high turnover and corresponding high expenses, your yields would be depreciated by a huge margin over the long term because, here, the yields are in the range of 5-9% on an average and, thus, even a 0.5% higher/lower expense ratio matters.
An excellent case of how PTR can help in investing would be that of mid- or small-cap fund as they are relatively under-researched stocks. Therefore, it?s possible that the fund has a high turnover. The accompaning graphic will give you an idea of what high portfolio turnover can mean. The funds in the table are of the same category, but with varying expenses and PTR. It?s seen that funds with low PTR and expenses, yield higher returns. Thus, as a thumb rule, all other features and comparable returns being the same, choose the one with a low PTR.
The writer is mutual fund analyst at Bonanza Portfolio