The Turnover Ratio Formula in Financial Analysis: Mutual funds use their consistent returns as a selling point to retail investors. In fact, even investors consider it to be a very important metric before picking a mutual fund, along with risk, fees, and lock-in period, if any. But what most investors don’t question is if the fund held the same stocks throughout the period it had made such returns.
Another important ratio to remember when researching mutual funds is the turnover ratio, also known as the portfolio turnover ratio. In this article, we’ll go through its meaning, importance, and the turnover ratio formula.
What Is The Turnover Ratio?
A turnover ratio, also known as the turnover rate, is the percentage of holdings of a portfolio or mutual fund that has been replaced in one year. To an investor, it shows how frequently the fund managers pick and drop off stocks from the fund.
It teaches you how asset management companies work and the strategy they follow when managing stocks in the fund or portfolio. If a mutual fund holds 100 stocks and has replaced 30 of them, its turnover ratio is 30%.
Importance Of Turnover Ratio
A turnover ratio, from a technical standpoint, may not be as significant. But from an investor’s point of view, it can be a point of concern. Asset management companies charge fees to investors on their different portfolios. Each fund has a different expense ratio, based on factors like active management and turnover ratio.
If the fund has a high turnover ratio, where the fund managers are constantly shuffling between different stocks often, it raises commissions for the AMC. Keep in mind that when AMCs make transactions with securities, it’s usually in the range of crores. Each transaction of this size is expensive, and that expense they incur is passed onto the investors.
The fees we’re talking about include commission fees, trading fees, and transaction costs.
A high turnover ratio in mutual funds indicates that :
1. Higher Cost:
Funds that are frequently rebalancing their holdings to the point where it was almost unrecognizable a year ago are expensive to investors. The trades and transaction costs add to the cost of the fund manager, a price that is usually passed onto the investors of the fund.
2. Regular Rebalancing:
Funds with a higher turnover tend to switch stocks much more frequently. While the trades and stock transactions are usually backed by research, it adds to the cost of the fund. A fund with a 100 percent turnover ratio indicates that it completely switched over its portfolio to new stock holdings.
In extreme situations and higher market volatility, the AMC would have to alter its fund style to keep up with the market. When the markets are stable, they allow fund managers to make changes to the fund holdings.
Alternatively, if a fund has a low turnover ratio, it means:
1. Lower Costs:
Funds that don’t frequently turn over their holdings, reduce the overall cost of managing the fund. This has a lower effect on the gains from the fund, leaving more for investors to benefit.
2. Performance Of Fund Manager:
The funds that have a low TR ratio indicate that they follow a “Buy & Hold” strategy. This could also mean that the stocks they hold have the potential for immense returns and the AMC has confidence in its investments.
3. Low Churning/Rebalancing:
The activity of funds with a low TR ratio indicates that the activity of the fund, including trading, would be lower than funds with a higher TR ratio. Stocks barely change hands and are held on till the end of tenure, in the hope of getting higher returns.
4. Market Condition:
When the markets are extremely volatile, asset management companies are aware of the risk and tend to lower their activity, owing to a higher risk. If the market is bearish, it presents fewer investment opportunities to fund managers, and a lower market value of the holdings, in case they want to sell.
Also Read: Significance Of Current Ratio – Formula & Examples Explained!
How To Use The Turnover Ratio?
The turnover ratio is just one of the factors to consider when investing in a mutual fund, but it isn’t the only critical factor. The turnover ratio does, however, allow investors to compare the turnover ratios of different funds to see how they fare, especially if they use the same investment strategies.
Comparing the PTR of two or more funds allows investors to compare the funds and pick their ideal investment option. It affects the returns that investors receive if any after the fund matures because of the overall cost of managing it and moving its holdings constantly.
If the fund manager is skilled to generate higher returns on such a fund, a high turnover ratio would be justified, after adjusting for risk and comparing the returns to similar funds. But you must also realize that such funds also have to pay higher capital gains tax as they generate better returns, apart from a higher expense than low turnover funds.
Turnover Ratio Formula, With Example
The turnover ratio formula is
PTR: Minimum Securities Bought/Sold / Average Net Assets x 100
- Minimum Securities Bought/Sold is the total amount of new securities that were bought or sold (whichever is less) in a one-year period and,
- Average net assets are the monthly average rupee amount of the net assets in the fund.
Let’s use the Portfolio Turnover Formula using an example. An equity fund, called 5 Star Equity Scheme, bought stocks worth ₹400 crores and sold stocks in its holding worth ₹500 crores. The average AUM (Assets Under Management) is ₹2000 crores.
The portfolio turnover ratio in the case of 5 Star Equity will be
₹400 Crores (Minimum Stocks Bought Or Sold) / ₹2000 Crores (Average AUM) = 20%.
Must Read: Magic Formula Investing in India – The Wizard Behind Gotham Funds!
PTR (Portfolio Turnover Ratio) is especially important for equity-based funds, where the volatility for equity securities is higher. Investors in mutual funds should consider all factors before making a decision, as investing involves risk and uncertainty. So make sure you consider every factor before investing your money and making a decision. Happy Investing!
1. What are the types of turnover ratios?
The types of turnover ratios include inventory turnover ratio, accounts receivable turnover ratio, accounts payable turnover ratio, and fixed asset turnover ratio. These ratios measure the efficiency and effectiveness of a company’s operations and management of different assets.
2. Why are turnover ratios calculated?
Turnover ratios are calculated to measure how efficiently a company uses its assets to generate sales. These ratios help to identify if there are any inefficiencies in managing inventory, accounts receivable, or fixed assets.
3. How is the turnover ratio calculated?
The turnover ratio is calculated using the following formula:
Turnover Ratio (TR) = (Minimum Securities Bought/Sold / Average Net Assets) x 100
The minimum securities bought/sold represents the total amount of new securities bought or sold (whichever is less) in a one-year period, while average net assets are the monthly average rupee amount of the net assets in the fund.
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