Mutual Fund Rating How To Interpret And Use Them

The growth in mutual fund investment is leading to an increase in the number of companies offering ratings for mutual fund schemes. DSIJ explains how to interpret and use them.




Slowly and steadily, mutual funds are becoming the preferred route of investment by individuals in India. The year 2018 saw the assets under management (AUMs) of domestic mutual fund companies increasing by almost 14 per cent in the first 11 months of 2018. This was primarily led by the growth in number of investors, which is estimated to have grown by 1.32 crore during the same period. The interesting part is that the retail investors have contributed in a big way in this increase. They now form more than 50% of the total AUMs of mutual fund industry.

The mutual fund industry on an average has witnessed an addition of around 10 lakh of SIP accounts every month. The monthly SIP amount has also increased from Rs. 6,222 crore to Rs. 7,985 crore at the end of November 2018. The overall folios of mutual funds have also grown by 1.25 crore to 6.7 crore.

One of the key factors on which the growth momentum of mutual fund industry hinges is the investing experience of the investors. If the experience is good, we will witness accelerated inflows; however, a bad experience will ruin this growth. The MF industry had gone through a rough phase during 2009-13 due to bad experience of the investors.

How you select MF schemes?

Therefore, selecting the right mutual fund scheme becomes crucial. Most of us do not follow a disciplined way of selecting a mutual fund. We normally invest based on gossip or rumour. Sometimes, a recommendation from our friend, or worst, trying to mimicking your friend’s portfolio is another common method of investing in MFs. The most prevalent method being investing in top rated funds. All the above ways of selecting funds might or might not work for you. However, you should understand the way MFs work that will help you to select the right funds that are suitable for you.

How Funds are rated

There are some prominent names that provide rating system for mutual fund schemes and are being used by the investors to zero in on their investment. The methodology used by them is almost similar. They take into consideration how the fund has performed historically as compared to its peers. For example, one of the international MF rating agencies with presence in India ranks funds each month based on their trailing 3-year, 5-year and 10-year risk-adjusted returns versus their peers defined by the agencies. Different weightages are given to returns for different periods.

The duration taken to arrive at the rating may be different for other agencies and may be different for different categories. For example, one of the Indian rating agencies uses only three-year and five-year returns data to arrive at the ratings. Similarly, for debt funds, the minimum duration for which the fund should be in existence is 18 months, otherwise the fund will be not rated.

After this, the rating agencies allow different filters in terms of assets under management (AUMs) to rate funds. What this means is that the fund with a threshold AUM will only be considered for rating. Some of agencies even use minimum number of funds available in the category to rate funds from that category.




Once the above process is completed, the agencies follow a bell-shaped distribution. The 10% of funds with the best rankings receive a 5-star rating; the next 22.5% get 4 stars and 35% after that earn 3 stars, the next 22.5% receive 2 stars and the bottom 10% of the funds earn 1 star. The important point to note is that such performance is evaluated based on relative performance of the fund in its category. Therefore, even if a small-cap fund has given a better return than a large-cap fund, it may still get lower rating (star) because of its underperformance in its category. 

The historical reason why ratings gained importance among investors is because earlier investors use to chase short term returns (which many of you even use today) and end up investing in wrong funds many times. Ratings provided them a tool to check the performance of the funds in the long term and identify funds that were less vulnerable to drastic changes in their performance in the near future. 

Do ratings predict future returns?

Many of us use the ratings to select better performing funds to build a portfolio of highly-rated funds with the expectation that such a process will ultimately lead to outperformance relative to a given benchmark. However, the rating agencies themselves acknowledge the limitation of ratings to predict the future winners. Ratings is merely a report card of the fund's past performance. Moreover, a study done by Vanguard, a US-based company with largest provider of mutual funds, shows that ‘on average, 39% of funds with 5-star ratings outperformed their style benchmarks for the 36 months following the rating, while 46% of funds with 1-star ratings outperformed their style benchmarks for that period. The figure also shows the average 36-month excess returns (versus the funds’ style benchmarks) over time, based on the median fund in each rating bucket. Here the top-rated funds are shown to have actually generated the lowest excess returns across time, while the lowest rated funds generated the highest excess returns.’ The study done for the funds rated between June 30, 1992, through August 31, 2009 also points that there is no systematic and statistically significant result showing consistency in their outperformance. 

Conclusion

Therefore, those who are constantly looking for higher ratings to select and invest may be heading for a disappointment as returns might not be repeated. Moreover, return is not the only correct parameter to select mutual funds. The fund you select should be aligned with your goals and risk appetite. Hence, if you have a financial goal to achieve in the next 10 years and you are willing to take risk, you can invest in small-cap equity funds, which are risky but give better returns than the large-cap and mid-cap funds in the long run. 

If you want to use rating it should at best be used as a starting point and should be supported by other analysis to figure out if you should invest in the fund.

A study done by Vanguard, shows that ‘on average, 39% of funds with 5-star ratings outperformed their style benchmarks for the 36 months following the rating, while 46% of funds with 1-star ratings outperformed their style benchmarks for that period.