Mutual Fund Churning: Meaning, Causes, Risks & How to Avoid

Many investors frequently switch funds in hopes of better returns. While making changes when necessary can be appropriate, constant buying and selling without a solid reason can lead to “mutual fund churning,” which may adversely affect the investment strategy. In this blog, we will explore what churning is, how it happens, and how to avoid it. SEBI also advises aligning investments with one’s financial goals and risk appetite.

What Is Mutual Fund Churning? 

Mutual fund churning refers to the excessive or unjustified frequent buying, selling, or switching of mutual fund investments. This can manifest as an investor constantly moving money between different schemes. Meanwhile, the buying and selling of securities within a fund is measured by the Portfolio Turnover Ratio (PTR). According to SEBI, high portfolio turnover can lead to increased brokerage and other transaction costs.

Understand Mutual Fund Churning Simply

Suppose an investor invests in an equity mutual fund. A few months later, they switched to another fund solely because of its better recent returns. Then, when the next fund performs well, they switch again. If these changes occur repeatedly without a clear investment-related reason, it can be considered unnecessary churning.

Situation	General changes	Potential Churning
Reason for changing the fund	Actual change in goal or strategy	Switching based solely on recent returns.
Decision-making process	After careful review	Repeatedly and in haste
Portfolio activity	As needed	Excessive transactions
Investor focus	Long-term investment plan	Short-term performance

Types of Mutual Fund Churning 

Mutual fund churning can occur primarily at two levels: the fund portfolio level and the investor level. While both involve a high volume of transactions, the nature of these transactions differs.

1. Portfolio-Level Churning

At this level, the fund manager buys and sells shares or other securities within the scheme’s portfolio. High portfolio turnover can be normal for certain funds due to their investment strategies; therefore, high trading activity alone does not necessarily imply improper practice.

2. Investor-Level Churning

This occurs when the investor frequently switches funds or redeems investments across different mutual fund schemes. When such changes are made without regard to investment goals, risk profiles, or other valid reasons, it can amount to unnecessary churning.

3. Not Every Fund Change Constitutes Churning

Modifying your portfolio is appropriate if your financial needs, goals, or risk appetite have changed. SEBI also advises investors to align their investments with their objectives and risk appetite, and to periodically review their financial goals.

How Does Mutual Fund Churning Work? 

Mutual fund churning occurs when an investor repeatedly switches funds without a valid reason. This process typically unfolds as follows

Step 1: Investing in a Mutual Fund

An investor puts money into a mutual fund with a specific goal in mind or in anticipation of better returns.

Step 2: A Short-Term Trigger Occurs

After some time, the fund’s performance appears to dip, the market falls, or another fund seems to offer better returns. This is where the idea of ​​switching arises.

Step 3: The Fund is Redeemed or Switched

The investor withdraws money from the current fund or switches it to invest in a different scheme. According to SEBI regulations, a ‘switch-out’ is treated as a redemption, while a ‘switch-in’ is treated as a purchase.

Step 4: A New Fund is Selected

Often, the new fund is chosen based on its recent performance or ranking, without verifying whether it is truly better suited to the investor’s investment goals.

Step 5: The Process Repeats

After a while, the new fund may fail to perform as expected, or a third fund might appear more attractive. Another switch occurs, and this cycle of repeated activity can turn into mutual fund churning.

Read Also: Top Reasons Why Mutual Funds Are Going Down

What Is Portfolio Turnover Ratio in Mutual Funds? 

The Portfolio Turnover Ratio (PTR) indicates how frequently securities within a mutual fund’s portfolio are bought and sold over a specific period. It helps in understanding the fund’s trading activity. SEBI mandates the disclosure of PTR for equity-oriented schemes.

Understanding the Portfolio Turnover Ratio in simple terms

A high PTR generally implies significant buying and selling activity within the portfolio, whereas a low PTR may indicate relatively fewer changes. However, a fund cannot be judged as good or bad based solely on its PTR.

Is a high PTR always bad?

No. In some actively managed funds, the fund manager may make significant changes to the portfolio based on investment opportunities or shifting market conditions. On the other hand, trading in index funds is primarily driven by changes in the index or fund flows. Therefore, it is important to evaluate the PTR in the context of the fund’s strategy.

Fund Type	How to understand PTR
Index Fund	Generally, limited changes to the portfolio may occur, such as those resulting from index adjustments.
Active Equity Fund	The PTR can be higher due to stock selection.
Long-Term Strategy Fund	It is important to understand the fund’s strategy when the Portfolio Turnover Ratio (PTR) is very high.
Debt Fund	Changes may occur due to maturity, interest rate, and credit strategy.
Tactical Fund	Increased trading could be part of the fund’s stated strategy.

Mutual Fund Churning vs Normal Portfolio Rebalancing 

Both involve changes to the investment portfolio; however, ‘mutual fund churning’ often entails changes made without a valid reason, whereas portfolio rebalancing is undertaken to maintain a defined investment strategy.

Base	Mutual Fund Churning	Normal Portfolio Rebalancing
Main Objective	Frequent fund changes, often without apparent need	Rebalancing the portfolio according to the defined asset allocation.
Basis of the decision	Recent returns, market noise, or emotional reactions.	Investment goals, risk level, and asset allocation
Method of change	Frequent and unplanned	As per need or scheduled review.
When is it done?	If another fund looks better	When the portfolio allocation changes from the prescribed limit
Impact on investment strategy	The long-term plan may change repeatedly.	It helps maintain the original investment plan.

Why Does Mutual Fund Churning Happen? 

There can be several reasons for mutual fund churning, but it often stems from frequently changing investment decisions without having complete information.

• Impact of Fund Rankings: Investors might immediately switch to a fund that appears to be performing better based on new rankings, without realizing that rankings fluctuate over time.
• Acting on Recommendations Without Verification: Sometimes, investors switch funds based on someone’s advice without considering whether the move is actually suitable for their portfolio.
• Ease of Switching: Switching funds has become easy thanks to online platforms. However, this convenience can often lead to an excessive number of transactions.
• Lack of Awareness Regarding Costs: Some investors fail to check factors like exit loads and tax implications before switching. Therefore, it is crucial to understand the total cost involved before making any changes.

What Are the Effects of Mutual Fund Churning? 

Frequent mutual fund churning can impact not only the volume of transactions but also the overall efficiency of the investment.

• Additional Costs: Excessive buying and selling within the fund can drive up brokerage and other transaction costs, which may negatively affect returns.
• Exit Load and Tax Impact: Some schemes may levy an exit load on redemptions made before a specified period. Additionally, switching funds may be treated as a redemption for tax purposes.
• Impact on Compounding: Frequent withdrawals or changes in strategy prevent the investment from having sufficient time to grow over the long term.
• Decisions made at the wrong time can be costly: Redeeming in haste can prevent an investor from benefiting from a market recovery or the fund’s future performance.

Conclusion

Changing mutual funds isn’t always wrong, but constantly switching solely based on seemingly better returns is not the right approach either. To avoid ‘mutual fund churning,’ investors should understand the reason behind any change before making it. The right decision is one that aligns with your investment goals and needs.

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