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Are funds churning their way to losses?

March 17, 2004 07:20 IST

More churning means more expenses in terms of brokerages/commissions. More expenses means lower return. If the fund portfolio is being churned very aggressively, there is a fair chance that it is losing more money than it is making.

A lot of investors seem to believe active fund management implies hyperactive churning of stocks in the fund's portfolio. Unfortunately, a lot of fund managers lend credence to this notion by actually 'behaving' in that manner. However, nothing could be further from the truth.

A high portfolio turnover or aggressive portfolio churning is not necessarily the best way to make money for the investor. In any case, it is certainly not the cheapest.

Churn doesn't equal growth
Diversified Equity FundPT Ratio1-Yr
Templeton Growth Fund52.0%140.6%
HDFC Capital Builder88.6%123.5%
HDFC Top 20095.5%140.2%
Franklin Bluechip102.4%142.5%
Franklin Prima Fund103.6%155.8%
HDFC Growth158.0%123.1%
HDFC Equity169.5%131.4%
(Portfolio Turnover Ratio according to January 2004 factsheet)

First let us understand what portfolio turnover means. Portfolio turnover is the amount of buying and selling activity in a fund. Turnover is defined as the lesser of securities sold or purchased during a year divided by the average of daily net assets.

A turnover of 100 percent, for example, implies that the fund has churned its portfolio completely over the period under review. In the above table, the portfolio turnover ratio indicates the lower of stocks purchased or sold over the period April 2003 to January 2004 divided by the average daily net assets.

Unfortunately in India, declaring the portfolio turnover ratio is not mandatory, so not many funds share that kind of information with investors. We chose mutual fund schemes of Franklin Templeton and HDFC Mutual Fund mainly because they are among the largest fund houses in the country that regularly declare their portfolio turnover ratios in a comparable form.

A lot of fund managers churn portfolios aggressively not necessarily because they believe it is the right mantra to clock growth, but because of pressure from investors and the asset management company to do as well as the Joneses.

Consequently, stocks that are currently posting above-average performance are dumped because 'above-average' is not good enough in these times. A good solid stock that has posted a small (and temporary) dip in quarterly earnings is punished by being dumped. Not many investors would have forgotten Infy's 40 per cent decline over 2 days after 'disappointing' quarterly results.

A lot of investors and fund managers sold the stock only to buy it a few days later at lower prices. While selling high and buying low is prudent investing, let us not ignore the fact that there is brokerage to be paid on both the transactions (while buying and selling), so unless the fund manager is going to be making a lot of money on that stock, churning of this nature may not be all that prudent after all.

A high portfolio turnover rate is even more surprising when you consider that most domestic fund managers can't get enough of Warren Buffet, the investment guru, and his style of investing. And when you consider the fact that Warren Buffet is a very 'inactive' investor who buys and sells stocks sparingly and even then only after much deliberation, we wonder if this professed admiration for Warren Buffet is for real.

Admittedly, Warren Buffet pursues the value-style of investing and is true to it, while growth-style fund managers certainly may need to churn more actively in line with their style.

However, at the end of the day churn is secondary, maximising investor gains is primary and if the latter is not taking care of the former then something could be wrong with the stocks selected by the fund manager despite the churning.

From the investor's perspective a higher churn is not a sign that the fund manager is doing something right. It could well be that a fund with a higher portfolio turnover disappoints on performance and a fund with a lower churn has done far better. In the table above, Templeton Growth Fund with the lowest churn (portfolio turnover ratio 50.2%) has the third best performance over 1-Yr (140.6%). On the other hand, HDFC Growth with the second highest churn (158.0%) is the most dismal performer (123.1%). So don't look at just the churn, look at whether the performance justifies the churn.

Investors need to keep an eye on expenses that can really depress a fund's performance. Churning adds to the expenses and is often a very large component.

At the end of the day, this erodes your fund's performance. If your fund has an unusually high churn which is not backed by performance, its time to review your investment and consider a fund manager who can strike the right balance between churn and performance.




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