If you feel tempted to realign your mutual fund investment, then you are not alone. The process of shuffling mutual funds is commonly called ‘churning.’ While churning helps to realign your current investment, experts usually discourage investors against too much churning. In this article, we’ll discuss what churning is and how it can impact your investment strategy.
What Is Churning?
Churning refers to excessively trading in clients’ accounts, often practiced by unethical brokers. They would push poor-quality investments not aligned with the goals of the investor to increase their commission. The process benefits the broker while it increases investment costs for the investor and lowers their return. And so, if any trading that doesn’t help the investor is churning.
When you invest through a broker, they might often recommend different investment schemes to you. But they must highlight choices that align with your financial goals and help you get better returns. Brokers are duty-bound to recognize your investment goals before making suggestions.
How Does Churning Affect You As An Investor?
Mutual funds offer easy options for portfolio diversification. But it also involves costs. There are costs to buy funds and an exit load on certain occasions. Investors also have to bear the stipulated expenses and expense ratios. These fees can have a significant impact on the returns. Investors can’t avoid paying the charges, but they can rationalize these expenses to lower overall costs. One method is to prevent shuffling too often. Churning lies on the opposite pole of the recommended method of staying invested for an extended period for better returns.
Impact of Churning
Whether or not should you churn often is a decision based on your investor’s persona. But learning how churning impacts your returns will lead to making a better decision. A simple exercise involving some calculations is all that you have to do to understand the effects.
Let’s first establish the ground rules for the exercise.
Amount of investment
Before starting, one needs to determine the amount and tenure of the investment. Say investing an amount of Rs 100,000 for five years.
Set your return expectation from the investment. In this scenario, let’s assume it is 15 percent.
Calculate exit load charges
You will need to bear exit load charges when you try to move funds from one investment to another. Let’s assume it is 1 percent.
We will consider two situations with and without churning to compare the results.
When the investor decides to stay in a single investment for five years, he incurs a transaction cost of Rs 100 (1 percent). At the end of the investment tenure, the portfolio garners a return of Rs 200,935.
Now let’s assume a situation where the investor churned his investment every year and incurred fees for every churning. With everything remaining the same, the investor receives a return of Rs 192,425 at the end of the tenure.
The above example clearly exhibits the impact of churning on the final returns. The investor earns more return when he doesn’t shuffle his funds. However, it is only a hypothetical scenario. In reality, return from different investments will vary, and so will the exit load rates.
Sometimes investors are tempted to churn their funds when market volatility rises.
When market volatility increases, churning becomes an option to safeguard one’s investment. During periods of increased volatility, the market has often registered a spike in mutual fund portfolio turnover ratio, which is the ratio of minimum securities bought and sold against average net assets.
Some factors that would govern your decision.
– Considering the ideal debt-equity ratio in your portfolio
– Whether to be an active or passive investor
– Your risk appetite
Long-term Tax Implications
Since the government has introduced a 10 percent LTCG tax on a return amount of more than Rs 100,000 a year, several investors churn funds to avoid paying tax. But since it also involves costs, it can impact long-term gain from an investment. If tax savings is your reason for churning, consider whether long-term gain or tax saving is your priority. Churning may help avoid tax but at the same time increases expense to lower profit.
Churning stands against the much-touted theory of long-term investment. Investors can consider rebalancing their portfolios based on changing preferences, macroeconomic factors, or tax rates, but it may not always be a wise decision. If one can ignore the short-term benefits and focus on the long-term gain, the return is always high.