How to Use the Turnover Ratio When Selecting Mutual Funds.

What is the fuss?

Past returns are often the most common metric an investor considers while selecting a mutual fund. However, for those who research and select mutual funds more thoroughly, expense ratio and TurnOver Ratio pop up as additional parameters to consider.

Online advice on how to use the Turnover ratio while selecting funds is divided. Some sources say to avoid funds with high Turnover ratio, while some advice to ignore it altogether.

In this post, I will explain turnover ratios and how I use them to evaluate mutual funds. Let's get started.

What is the Turnover Ratio?

Turnover basically means the rate at which you are replacing things. In the context of a Mutual Fund, it means the rate at which the stocks in the Mutual Fund’s portfolio are being replaced.

Example: A mutual fund has INR 100 Crore in Assets under Management. If INR 50 Crore value of stocks were bought in the year, the turnover ratio is 50/100, or 50%.

A fund with a 100% Turnover ratio means it is churning its entire portfolio in a year.

The mathematical definition of the Turnover ratio is below.

Turnover Ratio = Min (Value of Stocks Bought or Sold in a Year) / Average AUM in that Year        

There is no formal definition of a high or low turnover ratio. High or low is relative. A fund with 100% turnover is considered high and opposite of long-term holding of stocks.

Is High Turnover bad?

Let's say a mutual fund has a turnover ratio of 100%. It means that the fund manager is replacing all stocks in less than 1 year.

This sounds a little off, right? Does the fund manager not know how to pick stocks correctly the first time? Investing veterans such as Mr. Warren Buffet say that money is made in the stock market by enjoying compounding over the long term. Too much selling and buying new stocks disrupts the compounding effect.

Does this mean that as a retail investor, one should avoid mutual funds with a high turnover ratio? Well, not exactly! As an investor, you should primarily worry about your returns. Your returns are impacted by (a) the fees you pay to the mutual fund manager and (b) the annual returns you make from the mutual fund. Let's study these two parts, which impact your returns, in a little more detail.

Cost of High Turnover Ratio

If you have individually bought and sold stocks directly in the secondary market (through brokers such as Zerodha or Upstox), you know that brokerage fees are involved each time you buy or sell stocks. So, buying and selling too many stocks will increase the transaction fees.

Does this mean a mutual fund with a high turnover ratio will have a higher transaction cost associated with it? Well, No. A mutual fund will not charge the investor transaction fees each time it buys or sells a stock. The only fees charged by the mutual fund are the total expense ratio (TER). This includes all the costs borne by the mutual fund house to run the mutual fund, including the mutual fund manager’s salary, marketing costs, administration costs, etc.

So, as a retail investor, you need not worry that a high turnover ratio in a mutual fund will cost you more. But is there any other cost impact? Well, there might be. Typically, mutual funds with high turnover ratios might have slightly higher TER.

Why does a high turnover ratio equal higher TER, you ask? Well, the reason is that a higher turnover ratio means a higher degree of active fund management. This leads to more frequent analysis, buying paid research reports, the cost of deploying quant models, and a larger analyst team.

High turnover = higher TER is not a formal rule, and is also not always the case. TER is impacted by many factors such as fund size, etc.

Let's look at the four leading small-cap mutual funds below to compare.

Quant Small Cap Fund's turnover ratio is shown as NA on ET Money. However, it is 150% as of August 2024 (reference?here).

We see that the Quant Small Cap fund, which has the highest turnover of 150%, also has one of the highest Expense Ratios of 0.64%. Other small-cap funds with lower turnover ratios have lower expense ratios, except the HDFC Small Cap fund, which has a higher expense ratio with a low turnover.

Another point to note here is that the expense ratio does not increase proportionately to the increase in the turnover ratio. Example: if the expense ratio is 0.40% at a turnover of 10%. Then, if turnover increases 5 times to 50%, the expense ratio will not increase by 5 times to 2%. The increase in expense ratio is very small, as indicated in the above image. Further, the expense ratio is capped as per regulatory guidelines.

As a retail investor, one should not worry about a higher turnover ratio costing you more.

Returns of Funds with High Turnover Ratio

Let us now look at the important part. Do high turnover ratio funds give higher returns? It may seem like they do. Refer to the image below, comparing the same four small-cap mutual funds we compared in the earlier section.

We see that the fund with the highest turnover ratio (Quant Small Cap fund) also gives the highest long-term returns (3-year and 5-year annualized returns).

That is interesting! So, high-turnover mutual funds do not cost a lot more and give much higher returns. Then, one should only invest in mutual funds with the highest turnover ratio? Well, not so fast. Let's look at the reason why some mutual funds have high turnover ratios and then decide if these funds are the right fit for you.

Why do mutual funds have a high turnover ratio?

There are different styles of equity portfolio creation. The three most popular investment styles are as follows:

Value Investing

The value investing style, also known as a buy-and-hold strategy, tries to pick well-run companies with a good future growth strategy at discounted prices. It requires buying fairly priced or underpriced companies and patiently waiting for returns over the next 3, 5, or 10 years.

As value investing involves a buy-and-hold behaviour, it has a very low turnover.

Value investing is one of the oldest investment styles. Investing veterans such as Mr. Warren Buffet popularized it. However, patience is not the strongest virtue of modern investors, who crave quick returns. This tendency has popularized the next two investment styles.

Growth Investing

The growth investment style aims to make returns by buying high-growth companies, even if they are available at high valuations. The idea here is to find companies that will grow disproportionately in the near future. High-growth companies are available at higher premium prices. Even if some growth companies falter and give negative returns, other growth companies are expected to outperform and provide alpha for the portfolio.

Growth investing has a higher turnover ratio than value investing. It requires remaining invested for the short to medium term to reap returns from the growth cycle, which can last anywhere from 6 months to multiple years.

Momentum Investing

The new kid on the block, momentum investing, rides the positive momentum in stocks. This investment style does not stick to a company. If a stock is showing positive price momentum, the momentum is expected to continue for some more time before plateauing or reversing. Momentum investing invests in good-quality stocks showing positive momentum and exits any stock whose momentum has slowed down or is showing negative momentum.

The momentum investment style has a very high churn rate. Even good companies do not forever show positive momentum. Sometimes, momentum investing can churn the entire portfolio within a matter of quarters.

So, now you know that based on investment style, a mutual fund may have a higher turnover ratio or less. There is no definite evidence of which investment style gives the highest returns over the long term. This is something that time will tell. There is one certain thing: no matter which investment style you choose, as long as you are experienced and disciplined, you can make money in the stock market.

Of the small-cap funds we compared in the earlier two sections, Quant fund follows a momentum investment style and has a visible higher turnover ratio. Axis and HDFC Small Cap funds follow a more valuable investment style and have a lower turnover ratio.

Choosing Funds based on Turnover ratio

With the information on what the turnover ratio is, why it is high, and how it impacts your fund’s cost and returns, it is time to cover the last leg of the discussion. How to use turnover ratio to pick mutual funds.

I do not use the turnover ratio alone to determine which mutual fund to invest in. The reason is simple: I like keeping things simple. If the turnover ratio does not impact my mutual fund cost and may actually give higher returns, why should I worry about one more parameter while evaluating a mutual fund?

For mutual fund evaluation, I use expense ratios and long-term returns. These are what matter to me as an individual investor. If a high turnover ratio fund is making me good returns and not charging me very high fees, my investment goal is met.

The turnover ratio helps me guess at the fund manager's investing style. I typically prefer lower turnover ratio funds, as this relates to my own style of investing, which is a buy-and-hold one. However, I have recently invested in some momentum funds, including one managed by the Quant Mutual Fund discussed above.

Net-net, if a metric does not directly impact my cost or returns, I would not overcomplicate my mutual fund selection process.

As a retail investor, you need to evaluate using the turnover ratio as you deem fit. If you like the value investing style, select funds with a low turnover ratio. If you are like me and want to focus on the outcome and not on the process that goes into creating that outcome, you can ignore the turnover ratio metric.

Parting Thoughts

It is important to understand a metric well enough to decide whether to use it. I do not use turnover ratio as a primary criterion for picking mutual funds. However, it is an interesting metric for me to compare funds and see how different investing styles are performing over time.

Knowledge builds confidence. Without knowing, you might have always felt like you were missing out on using the turnover ratio in selecting mutual funds. Hopefully, now you know whether you want to use or not use turnover ratio. And if someone asks you, you can give your reason for using or ignoring this parameter.

Lastly, successful investing is about staying clear of the noise and being consistent with your investment framework. Every year, analysts and the investing world create new metrics to evaluate a company/fund, predict future cash flows, etc. (Adjusted EBITDA metric is doing the rounds in 2024). This prolongs the list of metrics a retail investor like us is expected to know and deploy while investing. Keeping it simple and sticking to the basics is a better alternative.

Hope that helped!

What is the turnover ratio of your favourite mutual fund? Knowing this ratio now, will it change your fund selection? Do share in the comments below.

Disclaimer: I am not a SEBI-registered investment advisor. I am sharing my views and experience here. Please do your own research before investing.