Portfolio Turnover Ratio
When you are doing a mutual fund, mostly you are focused on expense ratio, returns, the reputations of fund managers, and asset allocation. But in the equation of all these, we tend to forget about the most critical factor, and that is the PTR or portfolio turnover ratio. This ratio helps to understand an investor about the cost efficiency of the fund and their tax liability as well. Especially in long-term investments, knowing this factor is essential.
Here in this blog, we will be explaining the meaning of portfolio turnover ratio, why it matters, and how it can affect the investment with taxation. So, without any further ado, let’s get started.
What Is The Portfolio Turnover Ratio?
PTR or portfolio turnover ratio helps investors to measure how frequently the mutual fund holdings are bought and sold by the fund manager over a certain period, usually for a year. There is a particular rule to calculate the portfolio turnover ratio, that is,
Portfolio Turnover Ratio = Minimum of (Total Purchase or Total Sales) / Average Assets under Management (AUM).
*The word ‘minimum’ is used because it prevents double-counting transactions.
If the portfolio turnover ratio is 100% then it means that the fund replaces all its holdings once in a year. A lower ratio of 20% means you have to go for a buy and hold strategy and the higher ratio of 150% indicates frequent trading .
Reasons Why Every Fund Has A Different Turnover Ratio?
The turnover ratio of a fund always depends on two factors: management style and also on investment strategies. The reasons are,
- Index fund
Generally, this fund has a low turnover ratio because it aims to replicate a specific benchmark.
- Thematic or Sectoral Fund
During regulatory changes or sectoral rotation, or any market shift, these funds experience high turnover.
- Actively Managed Fund
This fund tends to have a higher turnover because the managers frequently adjust positions to capitalise on the market opportunities.
How This Portfolio Turnover Affects Costs
You might have seen that mutual funds charge a visible expense ratio, but the portfolio turnover ratio always comes under the hidden costs; that’s why these are not always transparent.
For trading cost, every time when a fund sell or buy any security it carries a transaction cost. These are bid-ask spread, brokerage fees, exchange charges and market impact costs.
These fees can consume a lot of your returns, especially when the fund experiences a high turnover. But if you are doing any individual trading, then it might seem inexpensive because the cumulative cost can be significant over a certain time.
High Operating Expenses
When you start frequently trading it basically increases the burden for two people, one is for fund managers and another is for back office operations. Due to this it will cause higher operating expenses which do not always reflect in the expense ratio.
Impact Of Portfolio Turnover Ratio On Taxation
Whenever the portfolio turnover is high, it will always lead to serious tax implications.
- For Long Term vs. Short Term Capital Gains
The Tax authorities differentiate taxation for short-term and long-term capital gains.
- For long-term capital gains that taxation is usually lower because these are taxed at preferential rates.
- Short-term capital gains are generally taxed at higher ordinary income tax rates.
Hence, the short-term capital gains are always taxed at a higher rate than the long-term ones. Remember, this tax is directly passed on to the investors when the fund distributes capital gains.
- Tax Drag
The decrease in potential income caused on by taxes is known as tax drag. The idea explains how taxes reduce returns, generally on investments. The term “tax drag” is frequently used to describe the difference in tax-sheltered and non-tax-sheltered investment vehicles.
How To Find The Turnover Ratio Of A Fund?
Find the turnover ratio by just checking three things,
- Follow the annual report of your Mutual Fund.
- Use any online financial platforms.
- Check the prospectus or factsheets of your fund.
To understand whether the ratio is normal or excessive, you need to compare the ratio across the other funds in the same category.
Wrapping Up
In the analysis of mutual fund turnover ratio is often an overlooked part, but it is one of the most essential things to make more informed decisions. According to experienced investors, a higher turnover ratio is generally negative, but it requires a closer look at your investment goals, time horizon, and taxability. So, what are you looking up to? If you are interested in mutual funds, do check out that turnover ratio and make smarter and more tax-efficient decisions. We hope our suggestions were beneficial for you, but before finalizing the transaction, talk to your financial advisor first.
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What does a PTR indicate?
A PTR indicates trading by the fund manager with frequent selling and buying of securities.
Are the trading costs included in a fund’s expense ratio?
Due to the turnover ratio trading costs are not included in the fund’s mentioned expense ratio but it can impact overall returns.
Can a Fund with a low expense ratio still have hidden costs due to the turnover?
Yes, it can. If this PTR is high, then it can cause a high hidden cost.
Why do index funds generally result in low tax liability?
Due to the low turnover index fund typically incurs less tax.
Disclaimer – This article is for educational purposes only and does not intend to substitute expert guidance. Mutual fund investments are subject to market risks. Please read the scheme-related document carefully before investing.
