Mutual fund ratings

Star ratings of mutual fund schemes can be misleading!

Most of the information that a normal investor relies on before investing in mutual fund schemes comes from self-styled industry experts, the pink papers and mutual fund houses that share perspectives and assumptions and in some cases monetary incentives.

Fund Houses, Advisors, Wealth Managers and Brokers aggressively market funds awarded 5-stars by rating agencies like Value Research, Morningstar and Lipper.

Unfortunately investors respond to industry hype and buy heavily into the 5-star funds. The advisors as well as mutual fund houses showcase and hard-sell 5-star schemes and induce buying and selling that reduces overall investor returns.

Now the obvious question, can past performance be predictive?

Most of the star ratings are based on past performance, average AUM (Assets Under Management), portfolio concentration, corpus size, portfolio turnover, subjective analysis, hunches and opinions. Well, some of them are based on outright biases.

Very few ratings are simple, objective, and independent. They fail to assess the decision-making capability of fund managers and neglect the qualitative parameters which are also of great importance.

 

Then how to select funds based on past performance to ensure market beating results for the coming year?

How ratings work….

A rating is a report card of a fund. It gives us an idea as to how a particular fund performed over a given timeframe against other funds in the same category or the benchmark index.

It certainly is a good starting point in the fund selection process. However it cannot be treated as the sole basis for selecting a scheme to invest in.

Ratings are based on past performance and there is no guarantee that this past performance will be repeated in the future.

There are several instances where funds with 1 or 2-star ratings have subsequently leaped to the 5-star category and vice-versa.

Some of the rating parameters that are quantitative in nature are based on the fund’s risk-adjusted return performance over various time periods. There are instances where funds which are highly volatile or risky could get an average rating even if they are yielding good returns.

What should your strategy be?

Apart from the most recent rating of a scheme you need to check the past ratings. A fund’s rating is not permanent in nature and can change.

If the rating of a fund in which you have invested falls below a certain level (say from 5-star to 3-star) you should keep the fund on your negative watch list. However you should wait for at least 2-3 quarters before redeeming from the fund.

In today's world one year has become ‘long term’! Hence investors are in the habit of regularly churning their investments to be in the latest 5-star fund. Rather than chasing top-performers, it is more important to look for consistent performers and avoid non-performers.

A major part of your portfolio needs to be in a few solid schemes with long and consistent track record. These schemes should form the core of your portfolio and should be in the ‘buy and forget’ mode.

Investors have the tendency of pouring money into the ‘5-star’ schemes. They are always on the look-out for the hot fund and in the process jump from one scheme to another that has recently moved from a 2 or 3-star to a 5-star category. After a few months this 5-star scheme becomes a 3-star and they exit at a loss to invest in the latest 5-star scheme. Moving money always costs money.

How many schemes rated 5-star one year back have retained their rating today?

Very few! A classic example is the Sundaram Small & Midcap Fund. It was a 5-star rated fund for a long time and was the first choice of investors. This resulted in huge amount of money getting invested in the fund. That was the beginning of the downfall. The huge amount of inflows left the fund manager with very little opportunities in the midcap space and this hampered the performance.

The investors who jumped into the scheme attracted by the 5-star rating were a disillusioned lot. Then the money started moving out of the scheme due to gross under-performance. Well, it looks like a blessing in disguise. Performance slowly improved and today it is a 4-star fund.

Why do most advisors then recommend 5-star funds?

The problem is that most financial advisors also recommend the 5-star funds that are the flavour of the day. Reason? Well it is easy to sell a 5-star fund vis-à-vis a 3-star fund and nobody wants to walk the extra mile.

Why are you telling me to buy a 3-star fund? This is the normal retort from investors. Why should an advisor work hard on research and recommend a 3-star fund where he may face several objections with no extra incentive for the sale?

Are we suggesting that ratings are useless?

Not at all! Rating agencies provide a valuable service to investors and keep the fund managers on their toes with constant scrutiny. However while ratings are important they can be deceiving. We are just suggesting that ratings can only be a starting point in the decision making process and should not be used as the basis for churning investments from one fund to another in the short term.

What are the pitfalls in ratings?

During a long term bull market the rating agencies as well as investors become complacent. Fund managers are tempted to enhance performance by risky momentum stock picks or by simply taking aggressive cash calls. Both these factors can lead to rogue trading or even outright fraud. The performance of JM Core 11 scheme as well as some other schemes of JM Mutual Fund in the recent past are classic such examples.

What should an investor do?

Investors should research a fund's past results. The investor needs to ask some questions to themselves or their advisors before investing or churning schemes. 

• Did the fund manager deliver results that were consistent with general market returns?
• Was the fund more volatile than its benchmark index (meaning did its returns vary dramatically throughout the year)?
• Was there an unusually high turnover of stocks in the scheme?

This will help the investor understand how the fund performed under different conditions, as well as what historically has been the trend in terms of turnover and return.

Bottom Line….

Selecting a mutual fund may seem like a difficult task, but defining your objectives and risk tolerance is half the battle. If you follow this bit of due diligence before selecting a fund you will increase your chances of success. Question your advisor on the logic of suggesting 5-star funds and whether the suggested 5-star schemes would remain in the 4 or 5 star category one year down the line.