The Portfolio Turnover ratio explained.

The Portfolio Turnover Ratio is a vital metric in portfolio management that indicates the frequency at which securities are bought and sold over a given period. The turnover rate of assets in a portfolio can provide insights into the investor, fund, or strategy type.

Although private investors may not be familiar with this ratio, I believe it is one of the most important. Understanding this ratio can help investors gain a comprehensive understanding of their investment patterns.

The Portfolio Turnover Ratio is a useful metric for revealing an investor’s behavior. When I first began investing, I considered myself a long-term investor. After understanding portfolio turnover, I realised that my investment activity was that of a high-frequency trader.

A low turnover rate indicates that an investor does not frequently trade securities over a year or a month. A high turnover ratio, on the other hand, indicates that an investor frequently trades assets.

A low turnover ratio is preferred if an investor is maximizing existing holdings. For example, investing in the best companies, and not missing out on opportunities by sitting on cash due to indecision. In contrast, hyperactivity is considered trading and is not the preferred method of investing.

However, a high turnover fund that can generate higher risk-adjusted returns compared to funds with a low turnover rate isn’t bad. A high turnover portfolio incurs numerous transaction costs and capital gains tax There are hidden opportunity costs, such as the power of compounding a great company over time.

The Portfolio Turnover Ratio can reveal a lot about a fund or investment manager’s Philosophy and if it is being followed. Monitoring the rate change year after year and diverging far from the average can help investors question if there are changes in a strategy.

What is the Portfolio Turn formula?

• Portfolio Turnover Ratio = Minimum of Stocks Brought or Sold ÷ Average Net Assets x 100.

Minimum of Stocks bought or sold: refers to the total dollar amount of new stocks purchased or the total amount of stocks sold (whichever is less) over one year.

Average Net Assets: refers to the monthly average dollar amount of net assets in the portfolio.

The ratio can be measured annually or monthly depending on how you manage your portfolio.

How to use the Portfolio Turnover ratio?

Let’s dive into an example to show how the ratio is used and what the percentage indicates. We will compare two portfolios one with a high rate and one with a low rate.

	Company A	Company B
Purchased Securities	$72 million	$126 million
Sold Securities	$48 million	$117 million
Average Net Assets	$163.5 million	$125 million
Turnover Rate %	29%	93.6%

Our formula is taking the smallest of the transactions and dividing it by the Average Net Assets to reveal our “churn” rate.

Company A $48m ÷ $163.5m = 0.29 x 100 = 29%

Company B $117m ÷ $125m = 0.936 x 100 = 93.6%

What this means is that Company A has changed its portfolio holdings by only 29% over one year. For Company B it indicates that the fund has changed over the same period by 93.6%. So, this percentage reflects the complete change in the holdings.

A fund with a turnover rate over 100% means that the holdings in the portfolio were all either sold or replaced with other holdings. A 5% change means the company has continued to hold existing positions with a 5% divergence.

Low or High Turnover?

Low Turnover Rate: A low rate means lower activity and stocks are rarely sold or purchased. There will be fewer costs associated with this lower rate, less brokerage fees, and transactional costs. It can also reflect conviction in the holdings especially if it is a buy-and-hold fund. Lower turnover rates with high concentration tend to perform very well over the long term.

High Turnover Rate: Higher rates over 80% are considered “high churn” and overactive. Funds can become expensive with higher transactional costs, and CGT to consider all resulting in higher management fees. Certain portfolios will have high turnover rates based on the strategy, whether it be a hedge fund or an arbitrage strategy all requiring frequent trades.

Both rates work if they follow a strict strategy. A high turnover implies that an investor may be looking to book profits and enter stocks at lower valuations. A low turnover ratio indicates the investor’s strong conviction about the companies.

During bull runs, portfolio turnover is higher across the board as money is being made and valuations are going up. In a bear market, it is lower as investors become more sceptical about adding a new position to their portfolio.

In Summary…

Investors often have a high portfolio turnover rate, with some boasting as much as 200-300% (Hyper traders). This means that their entire portfolio changes completely two to three times each year. It’s important to monitor this rate closely, as it reveals whether your actions align with your investment goals and strategy.

However, there are costs associated with short-term focused activity. Conversely, aiming for a low rate is not ideal either. Holding onto losers, and missing out on opportunities can result in a lower rate.

I sometimes have a higher turnover rate, but only because I change holdings when my thesis breaks or a company in my holdings can no longer deliver. My usually low turnover rate indicates that I put time into researching companies and only take positions on companies I want to hold long-term.

New investors typically have high turnover due to a lack of analysis, no goal or strategy, a lack of understanding or from following the herd.

It’s important to know the average holding period of your companies. Portfolio management is the last piece of the investing jigsaw, and optimising your activity can have a serious impact on your long-term wealth creation.

As a long-term investor, it’s essential to evaluate your portfolio churn. If you have a “buy and hold” strategy, a high conviction style, a concentrated portfolio, and are looking for quality compounders, then your turnover rate should match your investment philosophy.