Decoding Mutual Fund Star Ratings

Dear Friends,

Numerous Analysts, Ratings Agencies and Magazines in India including Value Research, CRISIL, Money Control, Outlook Money, Morning Star, and Mint rate the Mutual Funds in India. Most of them use the risk adjusted returns approach and rate funds which have been in existence for a while, the time duration varies depending on the type of fund and rating provider.

For Internet savvy investors, it’s a no brainer to pick the highest rated funds published by the rating agencies and invest in them. But the pertinent question to be answered is “Is it that simple to choose the best rated funds published by the rating agencies and invest in them?”

The answer to be above question is not a simple “Yes” and here I have tried to explain my point of view with some examples:

1. Mapping the Risk profile of investors to the funds. Franklin Smaller Companies Fund is rated “5 Star” by Value Research in the Mid and Small Cap Category. But is this fund suitable for a first time investor or an investor close to retirement?
2. Consistency in Ratings provided by different Rating Providers. Reliance Equity Opportunities Fund is rated No. 1 by CRISIL for the latest period as among the consistent performers in Equity Funds whereas Value Research has been providing a rating of “3 Stars” (5 Stars is the maximum or equivalent to CRISIL No. 1) for a long time now. Both Value Research and CRISIL are reputed organizations and in this case which one will you trust?
3. Embracing Rating Downgrades. HDFC Equity Fund is the largest Equity Fund in India and is managed by one of the finest Funds Managers in Indian Mutual Fund Industry, Mr. Prashant Jain. There has been a slump in HDFC Equity Fund’s performance in the recent period and its rating by Value Research has gone down to “2 Stars”. When readers post questions to Mutual Fund Analysts in newspaper and magazine columns, the standard answer that I see is “Stop further investment in the downgraded funds and invest in other schemes, every Analyst has a few picks”. You also get this constant advice that you should not be holding too many funds in your folio. In that case what is the investor supposed to do? The Fund Ratings change so frequently and how to you just stick to the top rated funds. This will be only possible by constant churning of Funds like what some people do with stocks in their portfolio. This defeats the purpose of investing in Mutual Funds.

The attached figure illustrates the calendar year performance of 10 largest diversified Equity/Balanced funds as on 31^st Dec 2014 since 2004. The letters denote a specific fund (exact scheme names are masked) and you can see that no fund has always remained at the top.

4. Fund Categorization. Equity Funds are categorized as Large Cap, Large and Mid-Cap, Diversified, Multi-Cap, Mid Cap, Small Cap, No-Cap, Balanced, Hybrid etc. by Analysts and Rating Agencies and there is no consistency among the players. Investors who understand markets would know that the risk and return profile of investing in a Large Cap oriented fund is different from the risk and return profile of a Mid Cap oriented fund. So a higher star rated Large Cap fund cannot be compared to a lower star rated Mid Cap fund even if the Mid Cap fund would have delivered better returns as the risk adjusted returns are compared within the Fund Category.

So, as investors in Mutual Funds what should be your approach?

• Sticking to funds from fund houses with solid track record and disciplined approach to investments is the key.
• Equity Funds should not be judged as performer or non-performer in short periods of time. While the time limit for your patience to stick to a fund that has been underperforming varies from case to case basis, don’t switch funds just because they underperformed for a few quarters or a year. It happens with every fund house.
• Try to analyse the reason for underperformance. It could be due to wrong bets taken by the fund manager, change in fund manager, change in the market cap of stocks invested (shifting from mid-cap to large caps) and so on.
• If you are concerned that you have an underperforming fund, talk to your Financial Advisor and find out the reason as why he/she recommends to stick to the fund.
• There are prudent ways to make fund switches in case you decide to switch from one fund to another and don’t sell the fund in one short, wait for the redemption proceeds and invest in another fund.

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