Impact of the Expense and Portfolio turnover ratio on the mutual fund performance

“There is no such thing as free lunch” is the popular adage indicating there is cost involved for everything and it is difficult to get something for free.  The same holds true for mutual funds which charges fees for managing pool of money and offering host of benefits to the investors. This fee also popularly known as the expense ratio covers all the expenses that asset management company (AMC) incurs. In addition, to generate returns and based on the changing market dynamics a fund manager churns the portfolio i.e., buys and sells stocks which is known as portfolio turnover ratio.  The article attempts to understand the impact of expense ratio and the portfolio turnover ratio on the mutual fund performance, interlinking between the two and need to evaluate them in detail apart from considering other risk and return parameters before investing.

Expense ratio

Expense ratio is the fees charged to the investors to meet the operating expenses of a fund.  Majority of these expenses are investment management fees, administrative fees, registrar fees, trustee fees, audit fees, custodian fees, cost of the investor communication, marketing and selling expenses such as agent’s commission, brokerage, transaction cost.  All these expenses and cost are collectively referred as ‘Total Expense Ratio’ (TER) 

Expense ratio tend to vary across equity and non-equity-oriented schemes.  The expense ratio is fungible in India where there no limit on any particular type of allowed expense as long as the total expense ratio is within the prescribed limit laid down by SEBI. Equity funds can charge a maximum of 2.25%, whereas a debt fund can charge 2% (annualised) of the daily net assets.  Effective from April 1, 2020 the TER limit has been revised as follows.

While expense ratio is not the only standalone criteria while choosing the fund.  But it is prudent to choose funds with lower expense ratio.  Here is the example explaining the impact of expense ratio on the fund’s returns.  So, an investment of Rs 20,000 in the fund with an expense ratio of 1.5% results in payment of Rs 300 to the fund house for managing of investor’s money in a year.  Other way to look at it is how the expense ratio drains your returns over the long term. For instance, Rs 5 lakh is invested in the equity fund offering average annualized returns of 10% resulted in value of investment growing to Rs 12.97 lakh in 10 years. But with the expense ratio of say 2% the investment value actually grows to Rs 10.79 lakh. On the flipside, if one invests in fund with an expense ratio of 1.5%, value of investment grows to Rs 11.30 lakh. In case of the debt funds expense ratio matters more as these funds offer lower yield compared to equity funds.  The example is just for the illustrative purpose. 

Note, an investor will not pay TER annually because the daily NAV is calculated after deducting all the expenses. The net asset value (NAV) declared daily by the fund houses are the net of fees and expenses.   Hence, TER directly impact the funds NAV and it is recommended to choose funds which have lower expense ratio to garner maximum returns.

Portfolio turnover ratio

Another important parameter to analyse funds’ performance is the portfolio turnover ratio (PTR).  This ratio indicates the churning the underlying portfolio of the scheme. In other words, how many times the fund managers bought or sold stocks under a fund over a period of time.   PTR is governed by the market scenario and the fund management style.  PTR is calculated by dividing either the total purchases or total sales, whichever is lower, by the average asset under management (AUM).  The ratio is typically reported for the 12-month period.

• A low PTR indicates less churning, lower transaction cost, fund management style is ‘buy and hold’ and aims to hold the stocks for longer horizon. The underlying market conditions is highly volatile or rangebound offering little opportunity to the fund manager to churn its portfolio.
• A high PTR refers to frequent churning which is likely to generate additional returns but at higher cost and risk. The fund manager adopts a tactical approach and the underlying market scenario is bullish or likely to rebound enabling fund manager to take more bets on buying and selling.

So does high PTR is always bad? The answer is no as there are some fund categories which have to do frequent churning such as flexi cap funds, multi-cap funds in which the fund manager has to switch between large cap, small cap and midcap companies as per the SEBI mandate. This can lead to higher turnover ratio.  On the flipside, passively managed funds such as index funds which replicates the index and fund manager may churn only in case of the change in the composition of the index and often have low turnover ratio.  

This is evident in the table below which lists down the expense ratio, portfolio turnover ratio and 3-year annualized returns of the CRISIL ranked one funds for the quarter ended March 2021. The list includes all the equity-oriented funds except for ELSS and exchange traded funds (ETFs).   

Source: CRISIL, Money control, Value Research

Note: Performance data is as on May 24, 2021 and ratio are as of April 2021

The table is for illustrative purpose only.  Please read all the fund related documents before investing

As seen in the table schemes expense ratio and portfolio turnover ratio are closely linked to each other. Funds with the higher portfolio turnover ratio typically have higher expense ratio. This is evident in case of flexi cap, multi cap, value and contra funds where there are more churning and higher expenses. On the other hand, index funds and ETFs have low portfolio turnover ratio and also lower expense ratio.   However, this is not same across all schemes in each of these fund categories.  It might vary across the schemes depending on the fund management style and fund managers’ expertise. Also, it will not be wise to discard a fund which has higher churning and expenses involved as there are several factors affecting fund’s performance.  At times fund with higher turnover ratio and greater expenses the fund has managed to give superlative performance.  This could be attributed to encouraging market trend and good investment bets by the fund manager.  Hence, before choosing the fund it is essential to check if the higher expenses and turnover has manifested in better returns.  Also, mutual funds are market linked investment avenues and hence several factors impact the funds’ returns such as underlying portfolio attributes, exit load, risk adjusted returns gauged from sharpe ratio and also funds which are consistent performers across all market phases.  Investors can easily get these details from the fund related document or seek the help of the financial advisor to choose schemes wisely.