Why You Should Stop Looking At Mutual Fund Star Ratings Now - Outside View by PersonalFN

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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.

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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.

Old Name Old Category/Type New Name New Category/Type
ABSL Advantage Fund Multicap ABSL Equity Advantage Fund Large & Midcap
ABSL Small & Midcap Fund Small & Midcap ABSL Small Cap Fund Small cap
ABSL Top 100 Fund Large cap ABSL Focused Equity Fund Focused
Canara Robeco Emerging Equities Mid Cap Fund Canara Robeco Emerging Equities Fund Large & Mid Cap Fund
Canara Robeco Equity Tax Saver Equity Linked Tax Saving Scheme Canara Robeco Equity Tax Saver Fund An open ended equity linked saving scheme with a statutory lock in of 3 years and tax benefit
Canara Robeco F.O.R.C.E Fund (Financial Opportunities Retail Consumption & Entertainment) Thematic Canara Robeco Consumer Trends Fund  Consumption and Financial Theme
Canara Robeco Medium Term Opportunities Fund Medium Term Income Fund Canara Robeco Corporate Bond Fund Corporate Bond Fund
Canara Robeco Savings Plus Fund Short Term Income Fund Canara Robeco Savings Fund Low duration Fund
Canara Robeco Treasury Advantage Fund  Money Market Scheme Canara Robeco Ultra Short Term Fund Ultra-short duration Fund
Canara Robeco Yield Advantage Fund Debt oriented hybrid scheme Canara Robeco Short Duration Fund Short duration Fund
DHFL Pramerica Inflation Indexed Bond Fund Bond Fund DHFL Pramerica Strategic Debt Fund Medium to Long Duration Fund
DHFL Pramerica Premier Bond Fund Long Term Income Fund DHFL Pramerica Premier Bond Fund Corporate Bond Fund
DSPBR Income Opportunities Fund Income Fund DSPBR Credit Risk Fund Credit Risk Fund
DSPBR Micro Cap Fund Micro cap Fund DSPBR Small Cap Fund Small cap Fund
HSBC India Opportunities Fund Flexi cap Fund HSBC Multi Cap Equity Fund Muticap Fund
HSBC Midcap Equity Fund Mid cap Fund HSBC Small Cap Equity Fund Small cap Fund
ICICI Prudential Corporate Bond Fund Corporate Bond Fund ICICI Prudential Medium Term Bond Fund Medium Duration Fund
ICICI Prudential Income Opportunities Fund Medium Term Income Fund ICICI Prudential Bond Fund Medium to Long Duration Fund
ICICI Prudential Indo Asia Equity Fund Indo-Asia Equity Fund ICICI Prudential Smallcap Fund Small Cap Fund
ICICI Prudential Regular Savings Fund Short Term Income Fund ICICI Prudential Credit Risk Fund Credit Risk Fund
ICICI Prudential Top 100 Fund Large Cap Fund ICICI Prudential Large & Mid Cap Fund Large & Mid Cap Fund
ICICI Prudential Ultra Short Term Plan Ultra Short Term Income Fund ICICI Prudential Corporate Bond Fund Corporate Bond Fund
Invesco India Active Income Fund Long Term Income Fund Invesco India Corporate Bond Fund Corporate Bond Fund
Invesco India Corporate Bond Opportunities Fund Corporate Bond Fund Invesco India Credit Risk Fund Credit Risk Fund
Invesco India Credit Opportunities Fund Short Term Income Fund Invesco India Money Market Fund Money market Fund
Invesco India Growth Fund Multicap Fund Invesco India Growth Opportunities Fund Large & Mid Cap Fund
Invesco India Medium Term Bond Fund Medium Term Income Fund Invesco India Ultra Short Term Fund Ultra-short duration Fund
Invesco India Mid N Small Cap Fund Midcap & Smallcap Fund Invesco India Multicap Fund Multicap Fund
L&T Emerging Businesses Fund Mid & Smallcap L&T Emerging Businesses Fund Small Cap Fund
L&T Floating Rate Fund Floating Rate Fund L&T Money Market Fund Money Market Fund
L&T Income Opportunities Fund Income Fund L&T Credit Risk Fund Credit Risk Fund
L&T Resurgent India Corporate Bond Fund Corporate Bond Fund L&T Resurgent India Bond Fund Medium Duration Fund
L&T Short Term Income Fund Short Term Income Fund L&T Low Duration Fund Low Duration Fund
L&T Short Term Opportunities Fund Short Term Income Fund L&T Short Term Bond Fund Short Duration Fund
Mirae Asset Emerging Bluechip Fund Mid cap fund Mirae Asset Emerging Bluechip Fund Large & Mid Cap Fund
Parag Parikh Long Term Value Fund Value Parag Parikh Long Term Equity Fund Multi Cap
Reliance Diversified Power Sector Fund Power Sector Fund Reliance Power & Infra Fund Equity scheme investing in power & infrastructure sector
Reliance Media & Entertainment Fund Media & Entertainment Sector Scheme Reliance Consumption Fund Equity scheme following consumption theme
Reliance NRI Equity Fund Multi Cap Fund Reliance Balanced Advantage Fund Dynamic Asset Allocation Fund
Reliance Regular Savings Fund - Equity Option Multi Cap Fund Reliance Value Fund Value Fund
Reliance Top 200 Fund Large & Midcap Fund Reliance Large Cap Fund Large Cap Fund
SBI Corporate Bond Fund Corporate Bond Fund SBI Credit Risk Fund Credit Risk Fund
SBI Emerging Businesses Fund Mid and Small cap SBI Focused Equity Fund Focused Fund
SBI FMCG Fund Sector SBI Consumption Opportunities Fund Thematic - Consumption
SBI IT Fund Sector SBI Technology Opportunities Fund Sector
SBI Magnum Equity Fund Large cap SBI Magnum Equity ESG Fund Thematic - ESG
SBI Magnum Gilt Fund - Short Term Plan Short Term Gilt Fund SBI Magnum Constant Maturity Fund Gilt Fund with 10-year constant duration
SBI Magnum Global Fund Midcap SBI Magnum Global Fund Thematic - MNC
SBI Magnum Monthly Income Plan Monthly Income Plan SBI Debt Hybrid Fund Conservative hybrid
SBI Magnum Monthly Income Plan - Floater Monthly Income Plan SBI Multi Asset Allocation Fund Multi-asset allocation
SBI Magnum Multiplier Fund Multicap SBI Large & Midcap Fund Large & Mid Cap Fund
SBI Pharma Fund Sector SBI Healthcare Opportunities Fund Sector
SBI Savings Fund Floating Rate Fund SBI Savings Fund Money market Fund
SBI Small & Midcap Fund Small and Midcap SBI Small Cap Fund Small cap Fund
SBI Treasury Advantage Fund Short Term Income Fund SBI Banking and PSU Fund Banking and PSU Fund
Sundaram Equity Multiplier Multicap Fund Sundaram Large and Mid Cap Fund Large & Mid Cap Fund -
Sundaram Flexible Fund - Flexible Income Plan Floating Rate Fund Sundaram Corporate Bond Fund Corporate Bond Fund
Sundaram Income Plus Income Fund Sundaram Short Term Credit Risk Fund Credit Risk Fund
Tata Long Term Debt Fund Long Term Income Fund Tata Income Fund Medium to Long Duration Fund
Union Small and Midcap Fund Small and Midcap Fund Union Small Cap Fund Small Cap Fund
UTI Equity Fund Large cap fund UTI Equity Fund Multi Cap Fund
UTI Floating Rate Fund Floating Rate Fund UTI Ultra Short Term Fund Ultra-short duration Fund
UTI G-Sec Fund Gilt Fund UTI Overnight Fund Overnight Fund
UTI Income Opportunities Fund Short Term Income Fund UTI Credit Risk Fund Credit Risk Fund
UTI Opportunities Fund Opportunities Style Fund UTI Opportunities Fund Value Fund
UTI Top 100 Fund Large Cap Fund UTI Top 100 Fund Large & Mid Cap Fund
UTI Treasury Advantage Fund Ultra-short term debt Fund UTI Treasury Advantage Fund Low duration Fund
(Source: PersonalFN Research)

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

- This is to analyse, if the fund has shown consistency in performance across various points and provides decent risk adjusted returns. Under this, each fund is tested and scored on various quantitative parameters like 1 Year Rolling Returns, 3 Year Rolling CAGR, 5 Year Y-o-Y Rolling Average Returns, and also on risk reward ratios like Sharpe Ratio, Sortino Ratio and Standard Deviation.

Testing on Consistency across market cycles

- This parameter is to ensure that the fund has the ability to perform consistently across market cycles. Here we compare schemes performance vis-a-vis their benchmark index across bullish and bearish market phases and accordingly score on its performance consistency and number of cycles survived. Underperformers will score low.

? Qualitative Parameters

Testing Portfolio Quality

- We believe, scheme should not hold highly concentrated portfolio. Therefore, we score schemes on portfolio characteristics like concentration of top 5 and top 10 holdings.

- To ensure that balanced funds do not hold low or unrated debt instruments, we also consider credit quality rating score of debt portion of the portfolio held by balanced funds

- Engaging in high churning can result in trading and high turnover cost. Therefore, in our process, we also score schemes on portfolio characteristics like portfolio turnover ratio and expenses, and penalise funds involved in high churning.

Testing on Quality of Fund Management

Apart from schemes, we also test the fund manager and consistency of the fund house. Here we check if...

- The fund manager is over loaded with large no of schemes. We score on parameters like fund manager to scheme ratio, i.e. no of schemes managed by a single fund manager. We believe a single fund manager should not manage more than 5 funds. If the number of funds managed by a single fund manager exceeds 5, we consider him overburdened.

- The fund manager has decent work experience. We score on the average work experience of all the fund managers in the fund house, to ensure the investors' money is in experienced hands.

- The fund house is not active in only raising AUM. For many years, in our process, we consider the duplicate schemes launched by the fund house and accordingly penalise the fund house if they have many duplicate schemes. Multiple schemes with same objective means low score for the fund house.

- Efficiency of the fund house in managing your money: We calculate the efficiency of the fund house by checking and scoring on the percentage of AUM performance, which helps us understand what proportion of the total AUM of the fund house is performing and what proportion is underperforming. It helps judge the efficiency of the fund house in managing the garnered corpus.

In our process, adequate weightage is given to each of the parameters mentioned above and the funds are scored on each of them. Based on the composite score, PersonalFN arrives at views on each fund recommend under various mutual fund research services.

You see, the process we follow at PersonalFN is much more comprehensive in nature. We do not rely only upon quantitative parameters that are passive in nature. The qualitative parameters we use, helps us project the long-term consistency and stability that can be expected from quality portfolio and fund management.

While we may not aim for top performers, what we look for is quality funds that can be consistent performers in the long run.

So the next time you look at Star ratings that are derived merely on the basis of performance numbers, it will be best to consider this criteria as a measure of the funds historical performance and not a measure of top-rated future performance.

P.S.: Did you ever try PersonalFN's premium research service 'FundSelect'? If not, it's good time to do so. We are now offering OVER 50 PERCENT DISCOUNT on fresh subscriptions to FundSelect. So, instead of the regular price of Rs 5,000, you will pay Rs 2,450 only for the first year of subscription. And if you subscribe now, you will also get Free access to our premium report, 'The Super Investment Portfolio'. Read on for full details...

This article first appeared on PersonalFN here.

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


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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4 Responses to "Why You Should Stop Looking At Mutual Fund Star Ratings Now"

Manoj Yagnik

Jan 16, 2019

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Apr 29, 2018

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