Twinkle twinkle little star, how I wonder what you are? - Outside View by PersonalFN

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Twinkle twinkle little star, how I wonder what you are?
Oct 1, 2010

What comes to your mind when you hear this? Yes you are right - the good old days of kindergarten. But here we are not reiterating the good old nursery rhyme which we all learnt in school.

We would like to the tell you that in the recent times, giving "star ratings" to a fund has been the latest trend adopted by many mutual fund research houses / rating agencies, in an effort to help investors to pick the "right" mutual funds. But, have you as an investor really questioned or researched yourself as to how these ratings are done? Never.

You simply have blind faith and follow the norm that more "stars" there are on the scorecard, better is the fund's performance. Well, that logic may sound good during our school days when a 5 star for our homework, connoted that we were good students.

But, please recognise that evaluating a mutual fund's performance is far different!

Let us understand, how these twinkle-twinkle little stars 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 lets 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--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 ensures the safety is taken is considered, as it 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. So, by judging this, you can come to know 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. Remember: 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 that you are familiar with the quantitative parameters, taken by the "star rating" mutual fund research houses / rating agencies, let's recognise one additional quantitative parameter that Personal FN considers.
  • Performance Across Market Cycles: This enables in understanding how a mutual has fared during every phase (bull and bear) of the market cycles. A study on this reveals the fund's ability in sailing through in rough waters, which results in selecting mutual funds which perform consistently.

    Now having understood the quantitative parameters commonly followed, we are sure you would be keen to knowing how qualitative parameters are of utmost importance.

    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.

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

    Let's understand the qualitative parameters which add to the long-term investment objective of wealth creation:

  • 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 manger 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...that's not good for you.

  • 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 a "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.

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 but the main core of a mutual fund is formed by its qualitative parameters which requires a microscopic analysis.

Now that you are familiar with the importance of having both the parameters, imagine how "stars" would look like without their "shine"; in our opinion some "stars" may not be visible at all. On the same lines, when a "star-based rating system" is not backed by a combination of qualitative and quantitative parameters, it loses its shine. Also, by just relying on quantitative parameters, mutual funds will tend to play musical chairs. A fund which is "5 star" rated today, may become "3 star" in the ensuing year.

As the recent financial crises has shown, the 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 Personal FN we have never followed an "issuer pays" rating model. Our ranking 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:
Parameters PersonalFN Rating Agency A Rating Agency B 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    

Parameters considered for Debt Schemes:
Parameters PersonalFN Rating Agency A Rating Agency B 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      

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

So, next time if your broker or distributor is selling you mutual funds on the basis of the "star ratings", please question them Why this sole dependence on quantitative parameters? Also, ask him whether these ratings (given today), would play musical chairs?

Remember, sole dependence on only the quantitative parameters, for selecting mutual funds for your investment portfolio, is not the right thing to do; because these stars (based on quantitative parameters) may not always shine.

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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