Equity mutual funds are of two types: One is known as the index funds, or passive. … Today, we would highlight an indicator of how actively the portfolio is managed by the fund manager.

How active is your equity fund manager?

The English translation of the article is as under:

How active is your equity fund manager?

Equity mutual funds are of two types: One is known as the index funds, or passive. In this category of mutual funds, the fund manager plays no role. The stocks are selected in the portfolio only because they are part of the index the fund is tracking. The other category is the actively managed funds. In this category, the fund manager plays an active role in selection of stocks and timing of entry and exit. We have discussed about these two categories earlier. Today, we would highlight an indicator of how actively the portfolio is managed by the fund manager.

If you open the fund fact sheet of many mutual funds, you will come across a ratio mentioned along with the equity mutual fund schemes – the turnover ratio. This ratio is an indicator of the level of activity in the portfolio. Higher the ratio, higher is the level of activity. So let us understand this ratio further and also see what the numbers mean.

Portfolio turnover ratio = the lesser of purchases or sales during the year divided by the fund’s AUM (Assets Under Management)

The turnover ratio would be mentioned in % terms.

Let us say a fund has total size of Rs. 1,000 crores. During a year under observation, it sold securities worth Rs. 200 crores and bought securities worth Rs. 300 crores. In such a case, the portfolio turnover ratio would be calculated as under:

The fund’s AUM = Rs. 1,000 crores

Purchases during the year = Rs. 300 crores àP

Sales during the year = Rs. 200 crores àS

Lower of the sales (S) and purchases (P) = Rs. 200 crores

Thus, the fund’s turnover ratio = Rs. 200 crores / Rs, 1,000 crores = 20%

This can be interpreted as follows:

During the year, 20% of the fund’s portfolio was changed. This could also mean that an average holding period for each stock would be five years.

A ratio of 20% or less would be considered as buy-and-hold strategy, generally. Some portfolios may also have turnover ratio as low as 5%. On the other hand, if the turnover is more than 100%, such a fund has an average holding period of less than a year for each of its holdings. This is a very highly active strategy.

Which is a better strategy – high turnover or low turnover?

Whenever this discussion comes up, the investors are interested in knowing which strategy is better. Well, the answer is not so simple. If only one strategy was proved to be better than the other, wouldn’t all the sophisticated fund managers only deploy that? Different investors use different methods to generate investment performance. Some are good at “buy-and-hold”, whereas some may be good at highly active approach.

Another factor to keep in mind is the costs of trading – each buy or sell transaction by the fund in subject to some cost – be it the brokerage, or the stock exchange fee, or the securities transaction tax. This means higher turnover would be associated with higher costs. A manager adopting the high turnover approach must be able to generate returns higher to the extent of the trading related costs, else the higher trading may actually be costly rather than something that adds value.

So keep an eye on the portfolio turnover ratio to see whether your fund manager is too active.