Here are guidelines on whether you should rely on Mutual Fund Star Ratings or not:
Off late, star ratings have become very popular in the selection of mutual funds. Mutual fund ratings evaluate the performance of the fund over a period. These ratings tend to influence investors’ decisions. Undoubtedly, the ratings provide a bird’s eye view of fund performance. Advisors may use these ratings as a reference point towards client portfolio construction.
Rating agencies like Morningstar, value research, ICRA rate mutual fund schemes. They arrive at these figures after considering a lot many factors. They look into fund returns over 3 year, 5 year and 10 year period.
Additionally, they may consider fund expenses and other risk-adjusted measures. Some agencies’ ratings are based on fund’s ability to preserve capital across market cycles. Others may give more weight to tax efficiency of the fund.
You also get too know the investment styles corresponding to the market capitalization of the fund. It’s given in the style box that was popularised by Morningstar.
Ratings give a relative comparison of fund’s overall performance. Ideally, a fund receiving a higher rating is considered superior haven. A lower fund rating indicates inferior haven.
Overall, ratings have made the selection of mutual funds a cakewalk. Particularly those who don’t possess a financial background, ratings are like a virtue. They can quickly identify good mutual funds for their investment portfolio.
Now you may wonder that “Are top-rated funds better performers always?”
Well, need not be!
Mutual fund ratings mostly indicate how the fund performed in the past. The past performance of the fund might not be replicated in future. Similarly, ratings too, do not guarantee superior returns in the future.
Historically, high-rated mutual funds might have performed better than the lower rated ones. But there’s no assurance of outperformance on a continued basis. There have been instances wherein 2 star rated funds have beaten 5 star rated funds.
At this juncture, it becomes necessary to look into the limitations of mutual fund star ratings.
Limitations of Mutual Fund Star Ratings
In mutual fund investing, past performance is as crucial as future potential. Mutual Fund ratings only tell one side of the story. They explain the view of the rating agency about fund’s history. In a way, mutual fund ratings are backward-looking in nature. These don’t reflect analyst’s opinion about the future potential of the fund.
One-size doesn’t fit all
Star ratings resemble one-size for all approach. In reality, every investor is unique in every aspect. Your goals might be different from your friend’s goals. You might be risk-seeker while others are not.
Ratings are given by agencies based on objective factors. These should not be perceived as buy/sell recommendations.
Mutual fund selection involves both subjective and objective factors. Choosing the top-rated funds might not necessarily help in goal-accomplishments.
For example: When you visit a footwear store, you will buy only the best-fitting shoe. You can’t buy a shoe which won’t fit howsoever good-looking it may be.
Choose an appropriate fund that conforms to your risk appetite and financial goals.
Each rating agency assigns weights to fund parameters to arrive at the rating. The slightest change in any of the parameters would cause the ratings to change. Today’s 4 star rated fund may be downgraded to 2-star. Similarly, today’s 1 star fund may be promoted to 5-star. It implies these ratings are volatile in nature. Additionally, you don’t come to know about the specific parameters and the assigned weights.
Such weights could vary from the importance that you assign to the fund parameters. Hence, a downgrade in fund rating doesn’t imply that fund has become useless for you as well.
How to use mutual fund star ratings?
Mutual fund star ratings suffer from several limitations. Still, these can be of great help if used wisely.
While scanning the mutual fund schemes, you usually come across a plethora of schemes. You need a starting point to separate the bad ones from the good ones. In such a case, you may use these ratings for an initial short listing.
Once the irrelevant funds have been removed, you may focus the important ones.
You may refer to these ratings even during your investment horizon. Ratings are based on past performance and may reflect consistency. Do a quarter-on-quarter comparison of the rating of existing funds in your portfolio.
A constant fall in the star rating reveals declining fund performance. In that situation, impulsive fund switching must be avoided. You have to maintain an emotional composure. There can be any reason for such a downgrade.
You need to seek the causes which led to such a fund downgrade. It can be anything like a change in fund philosophy or exit of the fund manager. If the reason which caused such a demotion lies low in your priority list, then you need not fret.
But if this reason weighs heavily on your investment criteria, then you need to take a call. You may decide to switch immediately; or start a Systematic Withdrawal Plan (SWP) to a better fund.
Conversely, steady rating upgrades reveal improvement in the performance. If the fund stays in the higher grades consistently, it indicates consistency in its performance.
Consider ratings as one of the criteria but not the benchmark. Examine other aspects of the fund as well. You may use financial ratios like Sharpe, Beta and Alpha.
In addition to this, due consideration may be given to expense ratio. A top-rated fund which has a higher expense ratio would be of no use. Similarly, if it has a standard deviation higher than your risk appetite, it’s irrelevant.
Meanwhile, don’t ignore other critical parameters like ability and stability of the fund house. Track record and tenure of the fund manager also plays a crucial role. Choose funds having a strong internal investment process. Finally, when it comes to money, the integrity of the mutual fund house should be given recognition.
Mutual fund rating is not an end in itself. It is a starting point towards a critical fund selection decision.