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.
