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Is it wise to invest in star rated MF schemes? - Outside View by PersonalFN
 
 
Is it wise to invest in star rated MF schemes?

In the recent times, giving "star ratings" to a fund has been the trend adopted by many mutual fund research houses / rating agencies, in an effort to help investors to pick the "right" mutual funds. And influenced by them, investors too fancy having star rated mutual fund schemes in their portfolio. But the question which arises to our mind is that, can these star rated funds be like real rock stars in the portfolio.

Today, interestingly the media - both print as well as the electronic media, also sermon about star rated funds so often, that it has an influencing impact on the minds of many of you. Banking on this environment, mutual fund distributors / agents / relationship managers too are busy persuading their clients to invest in star rated mutual funds. But question still remains unsolved, "are you buying rock stars or winning mutual fund schemes to your portfolio?" It is vital to recognise that just having blind faith and following the norm that more "stars" there are on the scorecard, better is the fund's performance; sounded good or logical during our school days when a 5 star for our homework, connoted that we were good students.

But it is vital to recognise that evaluating a mutual fund's performance is far different!

Let us understand, how these star rating are granted by most mutual fund research houses / rating agencies. Most of these ratings focus on the quantitative parameters such as risk-return trade off, average AUM (Assets Under Management), portfolio concentration, corpus size, portfolio turnover, etc., neglecting (sometimes completely) the qualitative parameters which in our opinion are also of utmost importance.

Before understanding how qualitative parameters are of utmost importance, let's review some of the quantitative parameters which the "star rating" mutual fund research houses / rating agencies consider.

  • Risk-return trade off: Most "star rating systems" primarily consider this parameter. Risk-return trade off simply measures the return generated by the mutual fund over a period of time (usually 3-Yr CAGR return) vis-a-vis its peer group and risk of investing in a scheme rather than in a risk-free instruments.

  • Average AUM & Liquidity: This parameter displays the corpus size (in value) of a mutual fund house in terms of the assets it manages, along with liquidity.

    Average AUM parameter is considered on a questionable and stupid philosophy, that larger the Average AUM of a fund, greater would be the ability of the same to tide over distress times. Yes, we call it stupid because the ability of the fund in sailing through distress times, is a function of its stock picking exercise, which is reflected through the investment processes and systems followed by the fund. The size of the fund and the corpus of AUM is irrelevant.

    Liquidity reveals the ease with which the portfolio (equity and debt) can be converted into cash. Higher liquidity is always preferable.

  • Portfolio concentration: This parameter reveals the over-exposure of a mutual fund to a particular company or a sector. By over-exposing a fund to a specific stock or a sector, the fortune of the fund will be closely linked to the stock and / or sectoral bets taken by the fund.

  • Portfolio turnover: This parameter measures the frequency with which stocks are bought and sold. Higher the turnover rate, higher the volatility. It is noteworthy that the fund might not be able to compensate the investors adequately for the higher risk taken. It also depicts whether the fund manager of the respective fund holds his portfolio with conviction towards the long-term fundamental portrayed by the security, or does he indulge in mere momentum playing. Hence, by judging this, you can assess how frequently the fund manager changes his stock bets.

  • Expense Ratio: There are annual expenses such as administrative costs, management salary, overheads etc. involved in running a mutual fund house. Expense Ratio is the percentage of assets that go towards these expenses. Every time the fund manager churns his portfolio, he pays a brokerage fee, which is ultimately borne by investors in the form of an expense ratio.

    It is noteworthy that, higher churning not only leads to higher risk (it could be a sign that the fund manager may have no conviction and is gambling), but also higher cost to the investor for all the brokerage charges and taxes incurred on every trade. Costs are always there and are deducted immediately, but the returns and a higher NAV are a hope for all investors.

  • Average Maturity, Modified Duration, YTM: These parameters are important while evaluating debt mutual funds.

    The average maturity refers to weighted average time until all securities in a debt portfolio of a mutual fund mature. Lower the average maturity; the better it is in terms of the interest rate risk and lower volatility.

    Modified Duration (MD), reflects the responsiveness of the debt securities' price when the interest rate scenario changes. It is based on the inverse relationship between the price of the bond and interest rates. By taking this parameter into consideration, the volatility of the debt portfolio is revealed.

    YTM refers to the rate of return anticipated on a debt portfolio, if held till maturity. It is also commonly referred to as the yield on the debt portfolio.
Now having understood the quantitative parameters commonly followed, we are sure that many of you investors would be keen to know how qualitative parameters are of utmost importance. It is noteworthy that qualitative parameters are able to produce more robust ratings as it takes into account a host of factors mentioned hereunder, to reflect more consistent performing mutual funds.

Moreover, they (qualitative parameters) go a long way in maintaining the financial health of your portfolio, which leads to wealth creation over the long-term.

The qualitative parameters which add to the long-term investment objective of wealth creation are:
  • Fund Manager's experience: Well, he's the guy who's managing your money invested in mutual funds, so knowing his experience in fund management will be valuable. It is noteworthy that the fortune of the fund will be closely linked to the way he manages the fund, and this is a function of the experience which he carries in the field of fund management and equity research. In some instances, the fund may be managed by a "team" even though there is the name of a specific fund manager in the documents.

  • No. of schemes to fund manager ratio: Many mutual fund houses frequently launched too many similar products, so that they could gather more Assets Under Management (AUM). This eventually leads to the fund manager being over-burdened in managing these multiple mutual funds, which can result in lower efficiency of the fund manager on focusing on the need of his investors.

  • Proportion of AUM performance: Some fund houses constantly engage in an exercise of increasing their AUMs, through frequent product launches. Well, that may be good in a way, but does not necessarily reveal that a fund house with a larger AUM, is good for you as an investor.

    Consider a fund house having an equity AUM of Rs 10,000 crore across 10 schemes. Now, if only 6 out of 10 schemes having an AUM of Rs 3,500 crore are performing while the rest 4 schemes with Rs 6,500 crore corpus are underperformers, then it can be said that only 35% of the AUM is performing. This brings out the fact that whether the fund house is really doing a good job in fund management or is just an AUM gatherer. But for you, as an investor, if your money ended up in the bucket of Rs 6,500 crore and was under-performing, then that may not do good to your portfolio.

  • Unique schemes: Frequent product launches, with an aim to increase AUM, in our opinion just do not make much sense. The fund so launched has to be unique - otherwise it is simply an "old wine in a new bottle".

    The higher the number of unique funds, the better it is. Duplication of funds by the fund house brings out their incapability of managing schemes in a prudent manner.

  • Investment Systems and Processes: The mutual fund house's ideology is reflected through this factor. The fund's instrument (stock / debt papers) picking is also a function of the investment systems and processes followed, which eventually links to the fortune of the fund.
Thus in order to have a more holistic approach towards investing, and for effective wealth creation it is imperative that one recognises both - quantitative as well as qualitative parameters, which go into selecting winning mutual funds. It is noteworthy that, while quantitative parameters depict the out layer of a mutual fund scheme which is visible to everyone, qualitative parameters (which require microscopic analysis) as cited above are inseparable from the analysis of mutual fund schemes.

Merely relying on star ratings (which are illustrated taking into account only quantitative parameters) may not enable you to have rock stars or winning mutual fund schemes in your portfolio. This is because when quantitative parameters undergo a change, mutual fund schemes would also play musical chairs. A fund which is "5 star" rated today, may become "3 star" in the ensuing year.

The financial crisis of 2008 has shown that credit rating agencies were happy to sell their star system to those who offered them money. The saddest part is that, this completely misled the investors.

Mind you, at PersonalFN we have never followed an "issuer pays" rating model. Our rankings are completely unbiased and independent, taking into account both quantitative as well as qualitative parameters.

We never, put anything before the interest of our investors'.

And that makes us unique.

Parameters considered for Equity Schemes
Rating Parameters PersonalFN Rating AgencyA Rating AgencyB Rating Agency C Rating Agency D
Qualitative          
Fund Manager's experience
No. of schemes to Fund Manager ratio
Proportion of AUM performance
Unique schemes
Organisational Structure
Accounting & Auditing
Quantitative          
Rolling & P2P Returns
Performance across market cycles
Risk-return trade off
Portfolio turnover
Portfolio concentration
(Source: Respective rating agency's ranking note and PersonalFN Research)


Parameters considered for Debt Schemes
Rating Parameters PersonalFN Rating AgencyA Rating AgencyB Rating Agency C Rating Agency D
Qualitative          
Investment Systems and Processes
Quantitative          
Performance Criteria
Portfolio Characteristics
Average Maturity, Modified Duration and YTM
Average AUM/Liquidity
Expense Ratio
(Source: Respective rating agency's ranking note and PersonalFN Research)

The above tables reveal the level of efforts that go into selecting a mutual fund scheme at PersonalFN.

Hence before you put faith investing in star rated mutual funds please assess how they are rated on various parameters. If your mutual fund distributor / agent / relationship manager has been emphasizing for star rated mutual fund schemes (which are principally rated based on quantitative parameters), ask him what is the rationale of this rating and whether they would play musical chairs.

Remember, it is your hard earned money and it is vital for you to take a prudent investment decision. Merely going by the star rated funds may not always provide sparkling returns to your portfolio.

Have you investors really questioned or researched yourself as to how these ratings are done, before you put faith on star rated funds? Never.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:
The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

 

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