Why You Should Stop Looking At Mutual Fund Star Ratings Now

Apr 25, 2018

Here's honest advice for every mutual fund investor - Stop looking at star ratings.

One of my friends is an ardent believer in Astrology. His morning begins with the predictions for his sun sign made by an astrologer on one of his favourite astrological blog.

Although he may not get his fortune right, he is quite happy when he knows the precautions he needs to take for the day; with his job, with his family, his friends, and enemies too.

Many of you might have a somewhat similar inclination for Astrology.

The word 'Astrology' is derived from two Greek words, 'Astra' which means 'a star', and 'Logos', which means a 'logic or reason'. It signifies the movement of stars and planets that can have influence on your life.

Do Stars Talk?

Of course, tracking them helps us predict the future or fortune of an individual or entity.

But do they really stand true in case of mutual funds?

Can they really predict the fortune for mutual fund investors? Or would they just be a redundant symbol, going forward?

To meet the SEBI's categorization and rationalization norms, mutual fund schemes are being re-categorized under different investment style, and many are being merged with other funds. In such a scenario, basing your investment decision on the past performance of the fund, which will now on be following different investment style altogether, is completely meaningless for you, the investor.

So would you rely on Star Ratings derived looking predominantly at such past performance numbers?

Say, for instance, you have invested in mutual funds for its 5-Star rating.

You were probably happy that you invested in a 5-star rated fund. This may even help you sleep peacefully at night.

Did you revisit the rating again? Has the fund, you had invested in, lost few of its stars?

What would you do in case it did?

You might simply stick with the fund you invested in, or else try to identify the next fund with a 5-star tag and switch to it.

Did you ever wonder why your fund lost its stars? Was it sheer bad luck or did it never had potential to continue retaining the spot?

If you find that, except performance, all other factors of the fund still remains unchanged, i.e. its fund manager, its investment style, concentration, etc.; then, probably you might have got your timing wrong.

I will tell you why.

Even Best Mutual Funds Can Have Phases of Good and Bad Performance Cycle

Every mutual fund follows a particular investment style, based on its objective and pre-defined strategy. Each investment style has its own cycle. A top performing fund that made the best in a bull phase of its investment style may end up among the laggards, if the style enters the unfavourable phase.

You probably invested in the fund after it had already made the most of the cycle and generated returns for its investors, which helped it gain maximum stars. By the time you identified the fund, the style was about to enter its next phase, which resulted in a slowdown in its performance, thus losing the stars for the fund. So did your investments.

Don't Fall For Passive Star Ratings to Predict Future Performers

Most mutual fund research entities follow the passive rating methodology, where they give very high weightage to quantitative factors like past performance and risk adjusted returns over a period of say 3 to 5 years and compare it with their peers to arrive at the best return generators in the lot.

In my understanding, these stars, derived from passive numbers at best, reflect how the fund has performed vis-a-vis its category peers over the last few years. Moreover, with the change in performance cycle, the ratings can change dynamically.

While looking at the past performance data of mutual funds is rational, what about the future growth potential and consistency of the fund?

What about the portfolio quality and investment style?

What about the portfolio maturity analysis, credit quality, and expenses that is significant while picking debt funds?

Where is the much-needed analysis about the fund managers skills and experience? And the investment systems and processes followed at the fund house, etc.?

These qualitative factors are more important than the historical performance, to judge the future growth potential and long-term consistency of the fund. Ignoring them completely, while arriving at the stars you probably use to select the funds for your portfolio, may never get you the real stars of tomorrow.

The interesting part is with the new classification and re-categorization of mutual fund schemes, these stars would be completely redundant and misleading if they are derived only on the basis of historical performance numbers.

What Has Changed For Mutual Fund Investors?

The age-old practice of using fancy names for mutual funds is almost redundant.

While some names were glorified, some were purely misleading. In terms of investment style, some schemes practiced completely different from their name or objective mandate.

To stop this practice and provide proper demarcation, in October 2017, the SEBI came up with its circular on "Categorization and Rationalization of Mutual Fund Schemes".

In the circular, the regulator defined 36 categories for mutual funds to make investing simpler for mutual fund investors.

In the circular, the regulatory body directed all fund houses to relook at their scheme categorization and realign their schemes and underlying portfolios to these new categories.

Following this, mutual funds have started announcing scheme rationalisation and categorisation as per the SEBI circular.

While it thought that due to rationalisation norms, several duplicate and fancy schemes would be merged with others and wiped out; the mutual fund houses have managed to retain most of their schemes, by tweaking their objective and style to match the new categories defined by SEBI.

Some Strange Re-Categorization...

Here is the list of schemes that have decided to switch their investment style to a different category, and are about to begin a new journey.

As you can see, many equity as well as debt schemes are expected to change their investment style and move to a completely new category. Their previous performance track record would not hold true for their newly adopted style. Moreover, there are some strange re-categorization that are done to keep schemes alive.

Some fund houses, like SBI, have gone a step ahead to adopt a new theme altogether. Creating a new ESG (Environment, Social and Governance) and changing the style of its large-cap oriented fund 'SBI Magnum Equity Fund', to a thematic fund, is something that was least expected.

Similarly, SBI Global Fund, which was a mid-cap fund focused on picking quality mid cap stocks, will focus on MNC stocks now onwards.

It seems, the fund house found it more convenient in changing the style and category instead of its name. You as an investor would definitely not stick to the funds that do not meet your objective.

In my opinion, mutual fund houses could have been more responsible in ensuring that investors do not face much hassle and their objective of investing in the scheme does not show much deviation. However, sticking to the schemes without re-evaluating the suitability of the new style to your investment goals can be risky for you.

It's Time To Look Beyond Stars And Performance...

So like we've established, with these changes, picking schemes based on ratings derived from their historical performance can be misleading.

These funds will need at least another 2-3 years to develop a credible track record which can be used to rate them.

Until then, they can be decided on their features, portfolio characteristics, and management quality. It is the time to give more weightage to fund and fund house quality and consistency over historical returns.

At PersonalFN, while analysing funds, we give weightage to both quantitative as well as qualitative parameters.

Here is the list of checks we do under our Quantitative and Qualitative Parameters...

? Quantitative Parameters

Testing on Performance Parameters and Risk Analysis