The turnover ratio is calculated by taking the lower of the total sales or total purchase and dividing this number by the average month-end net assets of the scheme. In other words, the minimum number of stocks bought or sold and divided by the assets under management (AUM).
It’s important to look at the turnover ratio for multiple reasons.
A higher turnover ratio is often indicative of a higher churn in the portfolio as compared to a long-term buy and hold manager who typically runs the portfolio with a lower turnover ratio. We think that a significantly high turnover could also be indicative of an inconsistent process. This could affect the overall returns of the fund over the long term.
The turnover ratio can indicate a manager’s investment style, for example a long-term buy and hold manager typically has a lower turnover ratio on his fund as compared to a manager who invests for the short term.
The turnover ratio of a fund could also be higher during a rising market as managers are able to find and leverage on a larger number of opportunities. On the other hand, a dearth of opportunities in a falling market could lead to a lower turnover ratio on the fund.
However…
Some fund houses tend to report two different turnover ratios, an overall turnover which includes the cash component and a second ratio which is the equity turnover.
The two numbers can tend to be starkly different, and it is therefore important to ensure that investors look at the right numbers while making a comparison.
It’s important that investors read the documentation carefully and ensure that they look at the underlying components that the fund company considers while making a comparative evaluation.
We think that it’s important to look at the turnover ratio of the fund in addition to other factors. Looking at the turnover ratio as a standalone factor may not the right approach when it comes to making investing decisions.
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