Churning leads to losses

Many a times, due to various reasons, investors are tempted to shift their investments from one fund to another. However, in the process what they fail to realize is that the shifting of investments comes at a cost. Redemption from an existing fund and subsequent reinvestment in the other, involves bearing costs in terms of exit load or entry load or in some instances even both. Over the long-term, these costs add up and have a detrimental impact on overall returns.

An analysis will make this clearer. Suppose an investor has Rs 200,000 to invest in an equity fund for the tenure of 5 years. For this he can choose either of the two options `A' or `B'. While under `Option A' he remains invested for the entire tenure, under `Option B', he shifts (or churns) his investments from one fund to another once every year i.e. in this case, the investment will be churned 5 times. Assume that, in both the instances, the entry/exit load for the funds is 2.25% and the expected rate of return is 15% CAGR (compounded annualized growth rate), which remains constant throughout the tenure for the funds.

Lets see, which option will prove to be beneficial for the investor over the long-term.

How portfolio churn hurts -

Initial Investment (Rs)	200,000
Load (includes entry and exit load) (%)	2.25
Annual Return (%)	15.00
Investment Tenure - 5 years	Option A	Option B
Maturity Value (Rs)	393,221	359,008
Return (CAGR) (%)	14.47	12.41
Savings (on account of no churn) (Rs)	34,213
Savings as % of Initial Investment	17.10
Investment Tenure - 10 years	Option A	Option B
Maturity Value (Rs)	790908	644431
Return (CAGR) (%)	14.73	12.41
Savings (on account of no churn) (Rs)	146,477
Savings as % of Initial Investment	73.23

As can be seen from the table, the maturity value at the end of 5 years in Option A will be Rs 393,221 while that in Option B will be Rs 359,008. Hence, it is apparent that the investor will save upto Rs 34,213 (which is 17.10% of the initial investment value) if he opts for option A.

Now let's consider that the investor wants to invest for a much longer duration of say 10 years. Here the disparity in the returns widens even further. If the investor decides not to churn (Option A), then he will save Rs 146,477, which is 73.23% of the initial investment. The same amount will be his loss if he opts for Option B. The disparity in the returns clearly shows the adverse effect that churning of portfolio can have on the returns.

The above analysis is based on the following assumptions:

1. The entry and exit loads for the funds are same. In reality the funds might have same or different entry loads and exit loads.

2. The rate of return from the funds is same and remains constant throughout the tenure. The returns may vary from fund to fund, however for better understanding it has been taken as constant in the calculation.

3. Option B churns once every year, depending on the tenure of investment. Again, churning of portfolio is an investor's decision. He may churn his investment twice a year or once in every two years, depending on his view about the ongoing scenario. The intention here is to explain to the investor the ill-effects of churning the portfolio.

Considering the negative impact of churning, the question is, why there is a need for investors to churn their portfolio? In our view, there is no need or there will arise no need if investors are invested in the right funds in the first place. Churning of funds should happen only when you are invested in the wrong fund. And if it happens quite often, then there arises a dire need for investors to verify their source of advice.

Here are three `wrong' reasons, which normally prompt investors to churn their portfolio:

1. They are asked to do so by their distributor/advisor. Distributors, in order to earn more commission, normally make unsuspecting investors churn their portfolio for their own benefit. Such distributors, in reality, do not inform investors about the charges (exit and entry load) involved. All they do is make a hollow promise that the new scheme will deliver better returns.

2. Some investors tend to churn their portfolio simply because they wish to own funds which have lower NAV (net asset value) as they perceive them to be cheaper.

3. Some investors churn their portfolio, because every time they do so, their agent passes back to them a portion of the commission he/she earns.

We believe that investments in mutual funds should be done after analyzing the fund on various selection parameters. And once that is done, there will in all probability be little reason for the investor to churn. Hence, whenever your advisor asks you to churn your portfolio, counter him with a question? Was the advice you gave earlier not the best for me? And watch him falling lack of words for the answer!

Churning of portfolio typically depicts lack of consistency and discipline in investing, the two most important virtues required while managing your finances. Hence, investors should imbibe and perform these virtues for their future benefit rather than churning their portfolio to losses.

source: personalfn

Note: Every person (Financial Advisor) is not the same. One can test his/her skills and knowledge by asking queries/ questions. We should choose Financial Advisor - who gives better services, who has knowledge about the Investment products, who has a variety of products to offer, who does not rebate the clients (Rebating is prohibited by SEBI so the investors should not seek it also), go by the credentials and qualities of person not because one of your known invested through him/her or he/she is your known to you. Loss or Profit depends not only of the part of Financial Advisor it also depends on other factors too. {We can have brief discussion on it}