COULD PORTFOLIO CHURNING HAVE A BRIGHT SIDE?

There cannot be only one narrative that frequent churning is detrimental to a portfolio’s health. For a mutual fund investor, the turnover ratio is always presented not in a very good light, despite it giving the desired returns.

A high turnover ratio can be a result of the fund manager taking a call on certain short-term opportunities emerging from global headwinds. It could be because certain sectoral and cyclical calls look promising. As seen in the recent past, the regulatory shift can also compel a fund manager to churn the portfolio.

It is true, though, that high churning without a substantial promising result can be counterproductive. In the absence of significant active management, the fund would appear to mimic the benchmark indices, and hence be more or less like a passive product with high expense ratio.

One may say that high churn demonstrates a fund manager’s lack of conviction. But the construction of a foolproof portfolio that can meet its objective over a period, usually long, also demands certain tactical calls. For example, in the event of corporate governance issues in the recent past, a few major companies of a group witnessed a free fall on both Nifty 50 and Nifty Next 50. A portfolio turnover call in such a scenario should be seen in a positive light. It helped cushion the impact on the portfolio for investors. Similarly, a few fund houses were quick to change the funds’ exposure to debt and equity, when the indexation benefit offered to debt fund was removed. The fund manager in this case was able to ensure that investors were able to meet portfolio objectives on time. Investors also got the flexibility to evaluate the portfolio based on risk and returns and accordingly decide to exit or continue with the churned scheme.

Need to be vigilant: As it is seen that there is a scope for alternative narrative, an investor should be sure that portfolio turnover ratio is not escorted by diminishing returns. The need is to keep a track of the fund’s return against the turnover ratio.

What the data says: Analysis of funds that have been in existence for a year offers some interesting insights. While lower churn has favoured large-cap funds, the funds with the highest turnover ratio have delivered better returns in the small- and flexi-cap space. The high turnover ratio is justified more in case of flexi-cap and small-cap funds, considering the universe is very large. There is always scope for a better stock to be included in the portfolio.

AUM size to turnover ratio: Funds with lower AUM, or assets under management, allow fund managers the space to churn portfolios, but in such cases, the composition is more inclined towards relatively stable businesses and longer holding periods. In the case of higher AUM, the turnover ratio decreases, and expense ratio gets spread out. But deployment of capital by higher AUM funds in small-cap stocks may increase their prices significantly, owing to which fund houses will have to stop taking further inflows to small-cap funds.

Higher turnover ratio is accompanied not only by higher returns, but also by higher expense ratios. Similarly, in the bullish phase, the funds with higher turnover ratio are seen to outperform. Investors must watch out for the phase in the market, as a bearish phase provides a true testimony for a fund with high turnover ratio.

Higher turnover ratio is accompanied by higher returns and higher expense ratios