Understanding how a mutual fund works can help you determine if it’s the right investment vehicle. One of the common areas of concern is around the frequency of stock changes in a mutual fund. Do mutual funds change stocks often?
Mutual funds change stocks from time to time, as fund managers shuffle the stocks portfolio to minimize risk and maximize returns. The frequency of the changes varies across funds with varying objectives. Prospective investors should analyze the portfolio turnover ratio to confirm the frequency.
This article will discuss why mutual fund managers change stocks and what the portfolio turnover ratio is all about.
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Table of Contents
Why Do Mutual Funds Change Stocks?
A mutual fund manager’s job is to ensure they generate the best possible performance from the market for any time window. This is especially true for actively managed funds where the managers are expected to be on their toes at all times, making the best decision possible for the investors.
One of the ways they achieve the results is to shuffle the stock portfolio from time to time. They don’t just change the stocks on a whim, but instead, they look at the market situation juxtaposed with their management theme.
For example, a mutual fund manager who works with a value theme will sell stocks that have reached their potential or those facing significant downside risks in favor of other stocks that hold more promise.
Similarly, a manager will add a stock to a portfolio or add more weight to it if he believes the stock is valued cheaply and has a great performance opportunity.
Other factors that can make a manager change stocks include negative projections about a specific sector, money inflows and outflows, bloated stock prices, and more.
Mutual fund managers have to make these decisions regularly, which is how they earn their investment fees.
How Long Do Mutual Funds Hold Stocks?
The holding time for the average mutual fund varies between six months and five years. Six months is the overall average hold time for stocks in general, as reported by a 2020 report from Reuters (link in article sources below), while the average long-term mutual fund remains investable for at least five years.
Again, the exact duration comes down to the type of mutual funds and the manager’s goals.
Stocks Analyses Change Frequency With the Portfolio Turnover Ratio
Instead of guessing how many times a mutual fund changes stocks, you can draw more informed inferences by looking at the portfolio turnover ratio. Let’s take a closer look at what this means and why it’s important.
What Does Portfolio Turnover Ratio of Mutual Funds Mean?
The portfolio turnover ratio is the rate at which assets in a fund, such as stocks, are bought and sold by the portfolio managers. It is the percentage change for the number of assets in a fund over the last year.
The ratio is calculated by dividing the “Minimum of Securities Bought or Sold” by the “Average Net Assets” and multiplying the result by 100.
The “average net assets” refer to the monthly average dollar amount for the net assets in the funds. The “minimum of securities” bought or sold is the total dollar amount of new securities purchased or sold, depending on which is lower, over the last year.
How to Interpret Portfolio Turnover Ratio of Mutual Funds?
If you arrive at a portfolio turnover ratio of 10% for a fund, it shows that around 5% of the portfolio’s holding has changed over the last year. If the sum amounts to 80% or more, almost all the fund securities have been sold or replaced in the last year.
The ratio provides a look at the approach a fund manager adopts when managing the fund.
If the ratio is lower than 30%, it’s a low turnover mutual fund where the manager tends to buy-and-hold securities. In most cases, passively managed funds tend to have a low turnover ratio, while actively managed funds have a high turnover ratio.
The results from a high turnover ratio are more reliable when compared with previous years.
Does the manager swing between low and high turnover ratio across multiple years, or has there been some consistency? Knowing this will give you a better understanding of what to expect.
Why Is Portfolio Turnover Ratio of Mutual Funds Important?
Knowing the portfolio turnover ratio for a mutual fund is important because it impacts the return you’ll get from the investment.
Mutual funds with a low turnover ratio are generally regarded as the better vehicles compared to those with a higher turnover ratio. So a mutual fund where nearly all the stocks are changed every year may not be the best for you.
Transaction costs are incurred as the securities are bought and sold, which will either reduce your return or lead to higher management fees. Similarly, a higher portfolio turnover ratio can also translate to higher capital gains taxes.
So, in many cases, a mutual fund with a high turnover ratio will likely incur more expenses compared to a fund with a lower ratio.
Does this mean you should avoid all mutual funds where the stocks are changed frequently? Not really. There’s nothing wrong with choosing high turnover funds as long as the manager generates risk-adjusted returns that are comparatively higher compared to a similar fund where the turnover ratio is lower.
If the high turnover ratio is accompanied by underperformance, it’s best to consider other mutual funds.
How Do Mutual Fund Managers Choose Stocks?
Now that you know why fund managers change stocks, it’s only natural to consider how they determine which stocks to pick and which ones to avoid. The main determinant here is the mutual fund type.
Let’s look at the popular ones below:
Index Mutual Funds
Index funds are built to mirror the performance of a chosen index. The managers of these funds can only change stocks if there’s been a change to the list of stocks on the index. The selection has to be identical for the returns generated to match.
So, when a stock drops out of the index, the manager has to remove it from the fund, and when a stock is added, it goes into the fund.
Growth Mutual Funds
Here, the focus is on generating profitable returns for investors in the long term by investing in companies that are likely to increase in value over time.
The fund managers are typically very active as they have to choose stocks of companies expected to grow in the short term, then quickly discarding them after the initial jump has occurred.
Dividend Mutual Funds
The goal of dividend mutual funds is to give investors the greatest dividend yield possible each year. To achieve this, managers pick out stocks that have paid the highest dividends in recent times.
In many cases, they stick with companies that have paid the highest increasing dividend over a time window. Other times, it’s all about unearthing companies that are on track to pay out high dividends in a year.
Arbitrage Mutual Funds
This is another type of mutual fund where the managers are typically very busy buying and selling stocks.
Here, the focus is on capitalizing on price differences between similar securities across different markets. It involves simultaneously buying and selling similar stocks, especially those with a wide enough spread to generate tangible profits.
Value Mutual Funds
The managers choose stocks of companies currently undervalued by the market, which means investing in low share price companies that are in good financial health and those with a decent dividend payment history.
Low share prices often signify that investors are ignoring the company for temporal reasons such as focusing on the shinier stuff or due to poor numbers in the last quarter.
Fund managers pick such stocks, knowing they’d return to the limelight soon.
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Conclusion
Mutual funds change stocks from time to time, but the frequency comes down to whether the fund is passively or actively managed.
Mutual fund managers in the former category tend to be more laid back in their approach, leading to a lower portfolio ratio. In contrast, those in the latter category are more actively adding and replacing securities, achieving a higher portfolio turnover ratio.
As an investor, you can choose between both divides by looking at projected returns and how they tie into your long-term investment goals.
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