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3 Vital Points to Keep in Mind Before Selecting Star-Rated Funds - Outside View by PersonalFN

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3 Vital Points to Keep in Mind Before Selecting Star-Rated Funds
Aug 11, 2016

South India superstar Rajnikanth starrer film Kabali earned over Rs 300 crore in the first four days of its release. The Rajni-fans from all over the world, in a frenzy, made a beeline outside multiplexes to watch the superstar in action.

Like superstars in movies, the Indian mutual fund industry too has star performers - star-rated funds and star fund managers. And unlike box office collections, their stardom is defined by the rating methodology of independent mutual fund research houses / rating agencies.

Interestingly though, these star ratings do not indicate and define everything about the fund. Nonetheless, they've grabbed the attention of investors for years - and that's simply because mutual fund distributors / investment advisors / agents / relationship managers have inscribed a belief that star fund managers and star-rated funds are the best. The media too, both print and online have played role in disseminating such notions.

But the question is:

  • Are star-rated funds evergreen?
  • Will they continue to shine like stars always?
  • Can they be the rockstars for your investment portfolio in the long run?

Stars are sold faster; but unfortunately, investors hardly bother to recognise the method behind their rating.

It is vital to understand that only having blind faith and following the norm that --the more "stars" there are on the scorecard, the 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.

Evaluating a mutual fund's performance is far different!

There are a number of criterions that a fund has to pass before it flaunts star performer status. PersonalFN, believes it is imprudent to blindly go by star ratings. As an investor, in the interest of your long-term financial wellbeing it is vital to delve deeper in understanding the methodology used for rating funds, because merely relying on star ratings cannot ensure winning mutual fund schemes for your portfolio, or a rockstar like performance.

Here are three important points to keep in mind before selecting the fund on the basis of star ratings:

  1. Importance given to quantitative factors
  2. The fund rating process mainly focuses on the quantitative parameters such as risk-return trade off, performance across market cycles, average AUM (Assets Under Management), portfolio concentration, corpus size, portfolio turnover, and so. It studies its past performance and indicates how the fund might perform at a given risk level in the future.

    The star rating process often neglects (sometimes completely) the qualitative parameters, which in our opinion, are also of utmost importance. Qualitative factors like fund manager's experience, number of schemes to fund manager ratio, organisational structure, proportion of AUM performing, unique schemes, investment systems & processes, amongst a host of others.

    In order to have a more holistic view of mutual funds, it is imperative that both the quantitative as well as qualitative parameters are considered in the rating process followed by the mutual fund research house / rating agency. These qualitative parameters form an inseparable part of the analysis of the mutual funds, as the quantitative parameters form the outer layer of a scheme which is visible to the naked eye, while the main core of a mutual fund is formed by its qualitative parameters which requires a microscopic analysis.

  3. Ratings are dynamic
  4. A 5-star rated fund today may become a 3-star next year. These ratings are assigned and revised on regular basis. It might even happen that a top performing fund might disappear from the market on account of consolidation or merger with another scheme. But the chances of a 5-star fund going off the rack is lesser than a 2-star or a 3-star rated fund.

    A fund might have gained stardom recently because its fund manager may have invested in top performing stocks or sectors. He might make mistakes as well and his decision might not result in profits as you expected. In such cases, if the fund fails to perform well, its rating might fall. That's why a qualitative assessment of the portfolio a fund is important.

    Hence the next time your relationship manager or mutual fund distributor tries to sell a star-rated fund, beware and conduct a due diligence at your end.

  5. Better star rating means higher returns
  6. A star-rated fund is often co-related with the fund generating high returns. But it is not necessary that a 5-star rated fund will be the best performing across categories. There are numerous funds with similar star rating. Not all the funds with 5-star rating generate super-normal returns always. Therefore, filtration of funds for your investment portfolio only on the basis of ratings is not enough.

    These twinkly little stars of a fund may not shine forever. A star fund cannot guarantee a rock-star like performance always!

    On the other hand, a downgrade in rating may not necessarily be a reason to worry. Every rating agency has a different process of evaluating funds (backed by an ideology), which needs to be recognised thoroughly before pressing the panic button.

To sum-up...

Star ratings can be indicatively used while selecting winning mutual fund schemes; but they can no way be the conclusive aspect. To simply put, one should refrain from finalising on mutual fund schemes based only on the number of stars assigned to them. Instead, doing a need-based analysis is necessary wherein you take into account your risk appetite, investment objective, investment horizon and financial goals, before you zero down on mutual fund schemes.

Also remember, sole dependence on quantitative parameters of mutual fund schemes is an imprudent thing to do; because these stars (based on quantitative parameters) may not always shine.

Hence, if a mutual fund distributor / investment advisor / agent / relationship manager emphasizes on star-rated mutual fund schemes, ask him what the rationale of this rating is and whether they would play musical chairs.

It is your hard earned money and it is vital for you to make a prudent investment decision. And do remember, when you invest in equity oriented mutual funds, have a time horizon of at least 5 years.

It was observed in past, that many rating agencies were happy to sell their star rating system to those who offered them money. This sadly misled the investors and is betrayal of their faith on the rating system.

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 investors.

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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