Star Rating Or Ranking? What Is Better?

When it comes to investing in mutual funds, a bad choice that many investors make is to simply park their funds looking at the star ratings provided by many rating agencies. Ideally, you should use rating as a screening tool. In this article we have discussed the different basis on which the funds are rated and ranked and why picking the best methodology is crucial for long-term returns

I n India, if you look at the sheer number of mutual fund schemes that are available for investors, the figure can be quite intimidating. There are more than 1,000 open-ended mutual fund schemes to select from. And it becomes really difficult for investors to individually review each and every fund before taking an investment decision. So then how should investors go about selecting a fund? Most rely on star ratings, which are recommended by rating agencies. They are quite different from credit rating agencies. Hence, it is important not to confuse between the two. In this article, whenever we say rating agencies, we clearly mean rating agencies that rate mutual fund schemes.

There are different rating agencies that have their own methods of rating or ranking of mutual funds. Value Research, Morning Star, CRISIL, Rank MF, ICRA are a few of the organisations that rate MF schemes. There are several others too. Hence, do understand how they rate funds before blindly believing and investing. Needless to say, you should not invest in mutual funds just looking at the star ratings. You should actually use it as a screening tool. In the following paragraphs we have discussed the different basis on which the funds are rated and ranked. Further, we would also try to find out for screening purpose which method is more robust and whether rating or ranking is better.

Different agencies rate mutual funds differently with their proprietary developed methodology. Though, it is quite difficult to understand how efficient they are, yet they can be used as your first screen. In this section we would look at the star rating methodology of one of the most prominent rating agencies in the business.

First Screen
For equity and hybrid funds, the fund ratings for two time periods of three and five years are combined to give a single assessment of each fund’s risk rating in relation with other funds in each fund category. For debt funds, the fund ratings are based on 18-month weekly risk-adjusted performance, relative to the other funds in the category. The performance data of equity or hybrid funds below three years and debt funds below 18 months are not rated. Further, each fund category should have at least 10 funds for it to be rated. Further, funds with assets under management (AUM) of less than Rs5 crore in the past six months are not rated.

Risk Grade
In order to calculate a mutual fund’s risk, monthly or weekly fund returns are compared against the monthly risk-free return for equity and hybrid funds and weekly risk-free return for debt funds. State Bank of India’s 45-180 days’ term deposit rate is assumed as risk-free return. Further, the magnitude of underperformance of the fund with risk-free return for all months or weeks is added and the relative performance of the fund is expressed as a risk score. The risk score of a fund is then assigned according to the following distribution:

Return Grade

This intends to capture the fund’s risk-adjusted return in comparison to other funds in the category. The returns – though adjusted for dividend, bonus or rights – are not adjusted for loads. The fund’s monthly or weekly return is compared with the monthly or weekly risk-free return to arrive at the fund’s total return in excess of the risk-free return. The monthly average risk-adjusted return is compared with the average category return to arrive at the final score. In case of a negative category average return, the risk-free return is used as the benchmark. A score in excess of one indicates that the fund has performed better than its category average and vice versa. The return score of a fund is then assigned a grade similar to the distribution of the risk grade.

Star Rating

Finally, the risk-adjusted rating is determined by subtracting the fund’s risk score from its return score. Moreover, the resulting number is then assigned star rating according to the following distribution:

We at DSIJ prefer ranking of mutual funds over rating. The reason will be explained shortly. But before we do that, let us understand how we rank funds.

“Don't look for the needle in the haystack.”​

We take advantage of our research strength and experience of understanding listed Just buy the haystack! John C. Bogle companies to ascertain the expected return on the underlying stocks of each equity fund. This helps us come out with a composite score, which we call mutual fund score (MF Score). Depending upon the MF score, we rank the funds without getting biased by the historical returns of the funds. This list is quite dynamic and reflect the best return potential of the funds for the next two years.

First Screen

Here we do not rank all the funds available. We do have some criteria to decide the universe of funds that we would rank. First of all, we only rank open-ended equity funds. In industry, many people don't rank sector and thematic funds as they are deemed to be tactical calls. But we do rank sectoral as well as thematic funds. We only rank funds having AUM greater than Rs 25 crores. This way we are able to rank a lot of funds.

We have evaluated each fund's underlying portfolio of stocks and ranked them based on their expected portfolio returns. In a similar way we calculated the risk of a fund based on its constituents. This helps us to 'rank' and assign 'risk' to newly launched funds also and we may not require longer period to evaluate their expected performance. We continuously evaluate equity funds based on the changed ratings of their underlying stocks and the change in their prices. Therefore, this list is quite dynamic and reflects the best possible return potential of the funds for the next two years. You can use this ranking to create your own mutual fund portfolio. Depending on your risk profile, return expectations and overall asset allocation, you can add the best performing fund category to your portfolio. For clarity and to include more funds, we have not included 'Direct' and 'close-ended' funds. Nonetheless, 'Direct' and 'Regular' fund will have same rank as their portfolio is same. Our ranking can also be used for reviewing different holdings in your fund portfolio. Hence, a consistently laggard performer of a category can be looked at as 'Switch' or 'Exit' advice.

Why is Ranking Better than Rating?

First of all, we are not against the rating methodology of any of the rating agencies. However, we are of the opinion that ranking is much better than rating. To provide you more clarity on our ranking philosophy, let us take an example of the multi-cap category. In this category, rating agencies have rated five stars for four funds, four stars for nine funds, three stars for 10 funds, two stars for seven funds and one star for two funds. So, we assume that the funds that can be potential buys would be 13 funds – four from five stars and nine from four stars.

However, as discussed at the beginning of the article, ratings or rankings are the first screen. So, once you have screened the funds, you have to carry out qualitative analysis such as looking at the asset allocation of the fund, portfolio, investment philosophy, fund manager’s track record, etc. Therefore, in case of rating you need to do it for each and every fund to come to a final decision. If we look at ranking, then it shows who has done relatively better and hence you know which fund you should be first looking at. Ranking will help you avoid wasting time on carrying out qualitative analysis on all 13 funds. Rather, it would help you find a better fund in the first few ranks itself.

Conclusion

While investing in mutual funds, interpretation of star ratings or ranking is very important. You should not interpret them similar to how you review star ratings of hotels. Star ratings or ranking should always be used as the first screen that would help you have only selected funds that you would need to further analyse. Hence, don’t straightway take investing decisions based on star ratings or rankings.

In one of our pervious issues we had an article on star ratings where our study found that one or two star-rated funds performed better than four or five star-rated funds and that to in a matter of six months to one year, which is quite a limited timeframe. Secondly, even as a screen, ranking proves to be better than rating as ranking reduces your unnecessary task of reviewing all funds.