Should You Buy Mutual Funds Based on Their Ratings?

With the growing popularity of mutual funds in India, inflows into schemes of all types have surged. According to AMFI (Association of Mutual Funds in India) data till March 2018, there were 71.35 million mutual fund accounts in India with individual retail investors accounting for 99.4% of these. In terms of allocation, 83% of investment accounts were equity oriented (pure equities and equity oriented hybrid) with an additional 13.5% of accounts invested in debt schemes while the remaining 1.5% were invested in money market/liquid funds. But this popularity has led to a problem for investors, especially new ones, – a problem of plenty. With hundreds of different schemes to choose from, it has become imperative that investors as well as analysts find ways to differentiate not only between different types of schemes but also similar schemes offered by different fund houses. One way of making this distinction is by assigning ratings to mutual funds. That of course leads to the obvious question – Should you base your mutual fund purchase decision on just these ratings? Read on to find out.

Mutual Fund Ratings: The Basics

The most commonly used way of rating mutual funds is by assigning star values – five stars represent the highest rating, while one star representing the lowest. The assignment of these stars depends on the percentile rank of the scheme within its chosen category. Which translates to the top 10% mutual fund schemes in the category getting the 5 star rating while the worst 10% of funds (in terms of performance) get the unenviable 1 star rating.

Mathematically, this ranking is provided by calculating the risk-adjusted historical performance of each scheme in the chosen category over various time periods. So in other words, the star ratings depict how a scheme has performed in the past based on returns provided and the potential risk to the investments made. In common practice, the time periods chosen to calculate these risk-adjusted returns are the 3 year, 5 year and 10 year trailing returns. The percentile ranking of the scheme is subsequently arrived at by combining these period-based risk adjusted returns. This is one of the key reasons why mutual fund schemes remain unrated till they have completed a minimum number of years of operation.

Should You Buy these Highly Rated Schemes?

In the above section, we have pointed out that mutual fund rankings show the historical performance of a mutual fund. For you that essentially means, in case you are already invested in the scheme and its rating has remained high or improved after you invested, there is a good chance that you are sitting on sizeable profits. But mutual funds are market-linked investments hence historic success does not guarantee that the scheme will be able to continue this performance in the future. In fact it is common practice for schemes to get rerated from time to time based on their recent performance. So a 5 star fund you make investment in today can be easily downgraded over the coming year and receive a 3 star rating due to its poor performance during the more recent period.

Thus, investing in a mutual fund on just the basis of its rating is a flawed plan at best. But, a highly rated fund does offer you better odds of picking a winner amidst market uncertainty. A change in mutual fund performance could occur due to a variety of reasons – out of favor investments making a comeback, mistake made by the fund manager when making an investment, change of fund manager/investment philosophy and so on. Therefore, while you should definitely consider ratings as one of the criteria when choosing your mutual fund investment but do not follow these ratings blindly. Some other factors that can aid you come up with a suitable investment option include age of the fund, fund manager’s track records, etc.

Using Ranking and Other Factors to Choose Your Investments        

To accurately compare schemes, it is essential that your comparison be made within funds of the same category. This is of course because you cannot rationally compare the performance or risk of a large cap equity scheme to that of an ultra short term debt fund. Additionally, multiple rating agencies offer mutual fund ratings and because there are often key differences in rating methodology, the same fund may be rated differently by different rating agencies.

Because the rating by itself cannot accurately portray the quality of the investment, you also have to consider your unique requirement. Are you looking for a short or long term investment solution, is liquidity more important to you than returns, how much risk you are willing to take, etc. The list of requirements can be as long or short as you desire, but do remember that mutual fund rankings are only a tool that might be able to guide you to the best choices. You have to choose your mutual fund investments based on your own unique needs!