What does churn indicate?

The markets seems to have found their firepower again and are galloping, and the charisma of equities which refuses to die 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 in the markets from all the quarters and as fallout the assets under management of the mutual fund industry have also demonstrated spectacular growth.

The focus in India has always been skewed towards active management of funds be in terms of stock selection or active buying and selling, and this active fund management to an extent has been reflected in the fund performance too. However investment theories invariably favors the benefits of long term investing as true value unlocking of any holding happens over a long period of time whereas, on the other hand frequent churning increases the expenses in terms of brokerage and taxes and thus lower returns.
This raises the question that should an investor prefer a fund that trades frequently or choose one that takes a long term call and stick 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 really induce portfolio churning are the style of investing and the prevailing market conditions. Investment managers often point that given the volatile trends in Indian market and extensive potential of equities portfolio churning is indispensable. For example, if the markets are booming and the fund has achieved its targeted return then it may prefer to churn its portfolio and invest in some more defensive stocks than it otherwise would have. Similarly if the markets are rangebound changing the portfolio composition may help to realize better gains.
Another important factor not to be ignored is market sentiments, which often forces fund managers to include momentum picks in their portfolio and however this a short-term strategy but nonetheless it adds to the churning rate. Also factors like unexpected redemption and change in fundamentals of the company may influence the fund manger to offload the securities. At the same time correction in the market provides them the significant opportunity to buy the stocks and deploy surplus cash if any which in turn impacts the portfolio turnover ratio.

So the question whether active churning of the portfolio is detrimental to the overall health of the portfolio or is it the ‘buy and hold’ strategy that enhances the return is not clearly evidenced from the facts analyzed. In practice long term investing always meant staying invested in a stock through thick and thin, though in today’s market it requires courage and skill to hold on to stocks for a longer time. As there is no fixed formula and what really works best for the investors is difficult to ascertain, but the fact can not be overlooked that portfolio churning does not come free of the cost as churning adds to the expenses and is often not a small component and may subdue fund’s returns especially when the markets are not booming.
At the end fund manager must be able to strike the right balance between churn and performance. If the fund has unusually high turnover ratio which is not justified by the performance a fund that has been rightly able to do so should be preferred. Churn the fund if it undertakes excessive churn and returns are not rewarding.

Although there is no direct correlation between portfolio turnover and performance, and high churning rate does not necessarily translates into better performance, but what it does mean is high costs for the fund. Therefore, an investor holding a fund with high turnover rate is justified in feeling that he should he 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.

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