The Role of Turnover Ratio in Mutual Fund Selection

What is Turnover Ratio?

Turnover ratio shows how much of a mutual fund's portfolio is bought or sold during one financial year. It is calculated by taking the lower value of total purchases or total sales and comparing it with the fund's average assets.

A higher ratio means that there is a lot of buying and selling, and a low ratio means the buy-and-hold. Such a metric will appear in scheme documents and fact sheets and will show the fund is employing an active or passive portfolio management strategy.

How to Calculate Turnover Ratio?

The turnover ratio is calculated using the following formula:

Turnover Ratio = (Lesser of Purchases or Sales) ÷ Average Net Assets × 100

Where:

• Purchases refer to the total value of securities bought during the year.
• Sales refer to the total value of securities sold during the year.
• Average Net Assets is the mean value of the fund's assets over the period.

Suppose a mutual fund has average net assets of ₹500 crore. During the year, it purchased securities worth ₹200 crore and sold securities worth ₹180 crore.

Turnover Ratio = (180 ÷ 500) × 100
Turnover Ratio = 36%

It is an indicator that the portfolio of the fund changed by 36% in the year.

Why Turnover Ratio Matters

The turnover ratio offers several insights for investors:

1. Cost Implications

   The net returns may decrease because of higher turnover that results in higher brokerage and transaction costs. The fund incurs these expenses and the returns of the investors are indirectly impacted.

2. Tax Efficiency

   Frequency selling will result in more portfolio churning and can result in investors realising capital gains earlier. In India, taxes are paid by the investor at the time of redemption but not at the fund level.

   As per the current rules, equity and equity-oriented mutual funds attract 20% Short-Term Capital Gains (STCG) tax if units are sold within 12 months. Long-Term Capital Gains (LTCG) are taxed at 12.5% after an annual exemption of ₹1.25 lakh.

   Lower portfolio turnover can help defer the realisation of gains, which may support improved post-tax returns for long-term investors.

3. Investment Strategy

   A high ratio often indicates active stock selection, whereas a low ratio reflects a long-term, consistent investment approach. Index funds typically have low turnover ratios, reflecting limited portfolio changes linked to index rebalancing.

4. Performance Consistency

   High churn can indicate a tactical or active style, but it usually increases transaction costs. Performance consistency depends more on the fund manager's stock-selection skill than on turnover itself.

Interpreting Turnover Ratio

Higher portfolio turnover can lead to increased transaction costs and may reduce tax efficiency over the long term for investors. Lower turnover usually reflects a consistent investment approach and reduced trading activity.

The usual range depends on the fund type and its goal. It should be compared with similar funds and the fund's stated investment strategy. A turnover ratio above 100% means the total value of securities bought and sold in a year is higher than the fund's average assets. This shows the fund has very high trading activity and frequent portfolio changes.

The turnover ratio is to be matched against other funds of a similar kind in the same category and against the established benchmark of the fund. In case the turnover is much higher than the average of the category, it can be the subject of closer consideration to evaluate cost-effectiveness and the alignment with the presented strategy.