The Irrelevance Of MF Star Ratings

Star ratings are profoundly used while making decisions regarding mutual funds investments. These ratings are based on past performance of the funds and certainly do not reveal anything about the future. DSIJ clears the air around investing in mutual funds, based solely on star ratings.



A new trend has emerged among the online shoppers. They go for a product with a higher star rating. However, in the mutual fund space,this trend is being followed for a while now. Many investors and their advisors trust the ratings given by various companies to mutual fund schemes. It helps them decide where to put their hard-earned money to gain maximum benefits. The size of mutual fund investment is increasing day-by-day and various reports suggest of it quadrupling in the next five years. These ratings are considered as the guidance to future performance. Higher the rating better will be the performance in future.

Nevertheless, our research shows that it is not case in most of the scenarios.

What are the rating systems?

Star ratings are something, in which mutual fund schemes are rated and given stars based on various parameters. There are several rating agencies, such as Morning Star and Value Research, to rate these schemes, speak specific method and set parameters. Usually, more stars indicate better performance of the scheme. Simply put, a fund with a 5-star rating is assumed to be better performing than a 4-star rated fund. Similarly, a 4-star fund is expected to have a much better future than a 3- or a 2-star rated fund. A 1-star rated fund is assumed to be worst performing among all. In India and all over the world, star ratings greatly influence investors. There is an analogy that persists among the investors that investing in a 5-star fund is the way to go about investing in mutual funds. However, the reality is much different than this.

The study

To understand whether making decision simply based on star rating is relevant or not, we carried out a study, wherein we have taken the average star ratings of funds as on September 2018 and assumed that investment would have been made in 5-star funds. After this, we checked their performance in the next 6 months’ period and repeated for another1 year period to understand their usefulness. We have also added an assumption to this study that after 6 months, that is, in March 2019, an investment is again made in 5-star fund. Further, we even checked its performance till October 16th, 2019.

For denotation purpose, we have put one star rating as 1, two star rating as 2, and so on in this study. The unrated funds are denoted as NR.

Mutual Fund Rating Methodologies

Risk and Returns Methodology

This is one of the common methodologies used by various rating agencies. In this method, at first the performance history of the funds is checked. For equity and hybrid funds minimum three years of history is required, whereas a minimum of 18 months of performance history is needed for debt funds. Those, not fulfilling this requirement, are not rated. Further, funds also need to go from an Asset Under Management (AUM) screening test. Different rating agencies have different AUM screening parameters. Some may consider a minimum AUM requirement of 5 crores; others may take 15 crores in consideration and so on. After this, the returns are combined with risk to get a risk-adjusted score. Here, generally standard deviation is used as a parameter of risk. Once the risk-adjusted score is available, star ratings are given. Mostly, this is carried out using the quartile method. This means that the top 10 per cent funds would get a 5-star, the next 22.5 per cent gets a 4-star, 35 per cent after these gets a 3-star, the next 22.5 per cent gets a 2-star, and the bottom 10 per cent receives 1-star. This is purely a quantitative methodology and no subjectivity is taken into consideration, whatsoever.

Advanced Quantitative Methodology

There are several rating agencies that rate funds based on additional parameters, apart from the risk and returns. In advanced quantitative method, they take average daily returns of the equity and equity hybrid funds. These are broken into overlapping periods of 36 months, 27 months, 18 months, and 9 months, and for other than equity funds, broken into 12 months, 9 months, 6 months, and 3 months,while taking returns into consideration. Further, they allocate weightage to such period to get the weighted average returns. Such weightage can be 32.5 per cent, 27.5 per cent, 22.5 per cent, and 17.5 per cent. The longest periods get the greatest weightage.

Here, some rating agencies also take active returns into consideration. For this, they usually compare funds with their respective benchmarks. The risk is considered the same way as we have seen in the risk and return methodology. Further, they also consider the concentration risk, which means that the less diversified or more concentrated fund gets a low score and vice versa. In case of index funds and ETFs (Exchange Traded Funds), they give due weightage to tracking errors as well.

Whatever methodology it may be, they are mostly based on historical performance. Such a methodology cannot predict the future. Even the founder of Morningstar, Mr. Joe Mansueto, has openly said in the media that the star rating is just a first stage screen to reduce the whole universe of funds to a much manageable one. Even many such rating agencies believe the same that it just shows the picture of how the funds have performed in the past. As we all know that no one can predict the market and, since mutual funds are very much a part of the market, they are also unpredictable. Still, there are various agencies, which claim market to offer research backed by Artificial Intelligence (AI) and all. However, there is no way you can be sure that the fund, in which you have invested, will perform in the future; hence, all this is nothing but a marketing gimmick. So, depending on the fund ratings and taking an investment call is not a good idea at all. Rather, instead of star ratings, you should look at various other things before getting into that fund.

Things that one should look at before investing in mutual funds instead of star ratings

Risk

This is one of the major factors that people usually ignore and just concentrate on the returns provided by mutual funds or other investment vehicles. Here, we are talking about the individual risk-taking ability and willingness and not the risk that the investment carries. Understanding your risk profile helps you select the right mutual fund or any other investment product, for that matter. Your risk profile should match with that of the mutual fund. For instance, if you are a conservative investor then investing more in small cap funds would be a bad idea.

Time Horizon

Another factor that people casually overlook is the time horizon. The general tendency of an investor is to earn a lot of money in the shortest period possible. However, for wealth creation, the more time you would give, the more wealth you would be able to accumulate. Hence, it is very important to you to decide the duration of the investment. If you wish to invest for two years then you would be better off investing in debt mutual funds. However, if your investment horizon is 5 to10 years then investing in equity mutual funds may prove to be rather fruitful.

Financial Goals

When you plan for any financial goal, both risk and time horizon is taken into consideration. Not just that, it is also prioritized, considering whether it is your need or want. Properly articulating your financial goals will help you in selecting mutual funds easily. If your financial goal is a need and is under a 3 years’ time frame then investing in debt funds sounds a better bet. Similarly, if the financial goal is a want and is 7 years away then you may look at equity mutual funds or even a combination of both debt and equity mutual funds.

We carried out the above study on the basis of the category to understand if the rating actually works for some of the categories. Here is the result:



For large cap funds, we can see that a 5-star fund performed better than others from September 2018 to March 2019. However, the story changes after that, since 1-star funds performed better than others during the period from September 2018 to October 16th, 2019.



In the large and midcap catagory, 5-star funds performed better than others during the period from September 2018 to March 2019. If you continued with the same till October 16th, 2019, your decision was right, as 5-star funds had continued to perform well than others. However, if you would have revised and invested in 5-star funds in March 2019 then the scenario would be different, since 1-star funds performed well than others during the period of March 2019-October 16th, 2019.



When it comes to midcap funds, 4-star funds performed better than others over the period of September 2018-March 2019. Even if we look at the one year between September 2018 and October 16th, 2019, 4-star funds performed better than others. However, if you would have reinvested in 5-star funds in March 2019 then you would have regretted, as 2-star funds performed better than others in the category over the period from March 2019 to October 16th, 2019.



If we take a look at small cap funds, then things turned out to be very different. If the investment would have been made in 5-star funds from September 2018 to March 2019 then it would have turned to be a disaster, as they were one of the worst performers. In the case of small cap funds, the funds that were not rated, performed way better than others in the category. If you would have continued with the original 5-star funds for the year between September 2018 and October 16th, 2019, you would have sincerely repented your decision, as they were the worst performer and, here too, the non-rated funds performed way better than that of other funds in the category.

It is interesting to know that during this 1 year, non-rated funds gave positive returns while funds with good ratings gave negative returns. Assuming that you kept your analogy of investing in a 5-star fund and revised your investment to always be in a 5-star fund in March 2019, you would have faced serious crisis, as 5-star funds were the worst performers over the period of March 2019-October 16, 2019, whereas, 2-star funds performed better than others in this category.



In case of multi cap funds, there was not a single fund that were rated a 5-star during the period from September 2018 to March 2019 and March 2019 to October 16th, 2019. In such cases, we have assumed that you would have invested in the next star rated funds, that is, 4-star funds. Having said that, if you would have invested in a 4-star fund in September 2018, you would not have incurred much of a success in wealth creation, since 1-star funds performed better than others in this category during the period from September 2018 to March 2019.

If you had held this till one year, then due to 2-star funds performing better than others in this category, your investment would have lagged behind. As we have a 5-star rating for March 2019, we assume that you would have upgraded your investment to invest in a 5-star fund. However, 1-star funds performed better than others in this category over the period from March 2019 to October 16th, 2019.

Conclusion :

Based on this study, we can say that it is irrelevant to take decisions just based on the star ratings and invest in a fund with the highest ratings. Our study showed that even the funds that were not rated or just had one-star or two-star ratings, performed better than that of five-star funds during the period of the study. It might be relevant in a short period, such as over a few months, but not in the long term.

Having said that, even if you decide to always invest in just five or four-star rated funds, then you might have to incur costs, such as exit loads and short-term capital gains tax. As we never drive our car by just looking in the rearview mirror, it is not at all a good idea to base your investments just on star rating, as they are purely based on the past performance. Rather, it is advised to have a financial plan and stick to it. Having a financial plan would help you invest in funds or in any other investment vehicle, for that matter, based on the investment time horizon and that too in a way that would suit your risk profile. Hence, before you go out and start investing in a five-star fund, stop and take a look at your suitability and requirement.