Portfolio Turnover Ratio: Definition, Calculation & Significance

The portfolio turnover ratio is the rate of which assets in a fund are bought and sold by the portfolio managers. In other words, the portfolio turnover ratio refers to the percentage change of the assets in a fund over a one-year period.

Formula for the Portfolio Turnover Ratio

The formula for the portfolio turnover ratio is as follows:

Where:

• Minimum of securities bought or sold refers to the total dollar amount of new securities purchased or the total amount of securities sold (whichever is less) over a one-year period.
• Average net assets refer to the monthly average dollar amount of net assets in the fund.

Interpreting the Portfolio Turnover Ratio

For example, a 5% portfolio turnover ratio suggests that 5% of the portfolio holdings changed over a one-year time period. A ratio of 100% or greater indicates that all the securities in the fund were either sold or replaced with other holdings over a one-year period.

The portfolio turnover ratio is important to consider before purchasing a mutual fund or a similar financial instrument, as it affects the investment return of the fund. Generally speaking, a low turnover ratio is desirable over a high turnover ratio. The rationale is that there are transaction costsTransaction CostsTransaction costs are costs incurred that don’t accrue to any participant of the transaction. They are sunk costs resulting from economic trade in a market. In economics, the theory of transaction costs is based on the assumption that people are influenced by competitive self-interest. involved with making trades (buying and selling securities).

In addition, funds with a higher portfolio turnover ratio are more likely to incur higher capital gains taxesCapital Gains TaxCapital gains tax is a tax imposed on capital gains or the profits that an individual makes from selling assets. The tax is only imposed once the asset has been converted into cash, and not when it’s still in the hands of an investor.. All else equal, a portfolio with a higher turnover ratio will be incurring more expenses than a fund with a lower turnover ratio.

However, it is not to say that a high portfolio turnover ratio is not desirable. A high turnover ratio is justified if the fund manager is able to generate comparatively higher returns (on a risk-adjusted basis) than a similar-style fund with a low turnover ratio. If the ratio is high, and the fund is underperforming its benchmark on a risk-adjusted basis, investors should be looking at alternative funds.

Portfolio Turnover Ratio and Investment Strategies

The portfolio turnover ratio provides insight into how a fund managerFamous Fund ManagersThe following article lists some of the fund managers that have been regarded as exceptional. This list includes investors that have created funds or managed very profitable funds. Fund managers included are Peter Lynch, Abigail Johnson, John Templeton, and John Bogle. manages its fund.

Generally speaking, a portfolio turnover ratio is considered low when the ratio is 30% or lower. When the turnover ratio is low, it indicates that the fund manager is following a buy-and-hold investment strategy. Funds with a low turnover ratio are called passively managed funds.

On the other hand, funds with a high turnover ratio indicate a considerable amount of buying and selling of securities (a fast-paced investment strategy). Funds with a high turnover ratio are called actively managed funds.

In addition, it is useful to track the ratio on a trended basis. It is done to determine if the fund manager’s investment strategy has changed. For example, a portfolio turnover ratio change from 20% to 80% over a three-year period would indicate that the fund manager has dramatically changed investment strategies.

Practical Examples

Example 1: Calculating the Portfolio Turnover Ratio

A fund purchased and sold $10 million and $8 million of securities, respectively, over a one-year time period. Over the one-year period, the fund held average net assets of $50 million. What is the fund’s portfolio turnover ratio over the past year?

Solution: The portfolio turnover ratio for the fund is calculated as ($8M / $50M) x 100 = 16%.

Example 2: Inferring the Investment Strategy Through the Portfolio Turnover Ratio

A fund prefers an investment strategy of capitalizing on changing market conditions. The fund’s portfolio turnover ratio was reported to be 95%. What would it imply about the fund’s investment strategy?

Solution: Due to the fund’s portfolio turnover ratio of 95%, it would imply that the fund follows a fast-paced and aggressive investment strategy.

Additional Resources

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In order to help you become a world-class financial analyst and advance your career to your fullest potential, the additional resources will be very helpful:

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