Is portfolio churning the best policy?

Aditya Agrawal

The equity market seems to have found its firepower again. The charisma of equities has been so intense that even the most conservative of investors have not hesitated to take a call on the markets. The money has flown into the markets from all quarters and the assets under management of the mutual fund industry have seen spectacular growth.

The focus in India has always been skewed towards active management of funds, be it in terms of stock selection or active buying and selling. This active fund management to an extent has been reflected in the fund performance too.

However, investment theories invariably favour long-term investing as true value unlocking of any holding happens over a long period of time. On the other hand, frequent churning increases the expenses in terms of brokerage and taxes and thus lowers returns.

This raises the question: Should an investor prefer a fund that trades frequently or opt for one that takes a long-term call and sticks to its holdings for a longer time?

Portfolio turnover ratio assumes importance here as it provides some meaningful information on the fund’s investment strategy. It is defined as the lesser of securities sold or purchased during a year divided by the average of daily net assets. A ratio of 100% means that fund changes its portfolio once over the year.

Given that long-term investing is the best way to take advantage of equities, the factors that induce portfolio churning are the style of investing and the prevailing market conditions.

Investment managers often say that, given the volatile trends in the Indian market and the extensive potential of equities, churning is indispensable. For example, if the markets are booming and the fund has achieved its targeted return, it may prefer to churn its portfolio and invest in some more defensive stocks than it would have done otherwise. Similarly, if the markets are rangebound, changing the portfolio composition may help to realise better gains.

Another important factor is the market sentiment, which often forces fund managers to include momentum picks in their portfolio. Though this is a short-term strategy, it none the less adds to the churning rate. Also, factors such as unexpected redemptions and changes in fundamentals of a company may influence the fund manger to offload a security.

Moreover, a correction in the market provides fund managers with an opportunity to buy stocks at the prevailing lower levels and deploy the surplus cash elsewhere.

So is active churning good for the overall health of a portfolio or is ‘buy and hold’ the best policy? The answer to the question is not a clear yes or no.

In practice, long term investing always meant staying invested in a stock through thick and thin. In today’s market, it requires courage and skill to hold on to stocks for a longer duration.

There is no fixed formula and what works best for investors is difficult to ascertain. However, the fact cannot be overlooked that portfolio churning does not come free. Churning adds to the expenses and it is often not a small component. This may subdue a fund’s returns, especially when the markets are not booming.

At the end, the fund manager must be able to strike the right balance between churn and performance. If the fund has an unusually high turnover ratio which is not justified by its performance, it should not be preferred.

An investor holding a fund with high turnover rate is justified in feeling that he should be compensated in terms of returns for all the extra costs that the fund is incurring. Over time, portfolio turnover rate becomes an important number to look out for while selecting a fund and informed investors will be well advised to look for best of both the worlds.

The author is joint MD of mutualfundsindia.com, a unit of Icra Online. Views are personal.