Dangers of relying on mutual fund star ratings and past performance

Published: August 14, 2018 at 7:23 pm

Last Updated on

Readers may be well aware that I am no fan of mutual fund star ratings. Star ratings and past performance if not understood with the right perspective can result in mistakes. In this post, let me give you an example – of my laziness that lead to a mistake in the July 2018 Equity Mutual Fund Performance Screener which is of course entirely based on past performance. The screener which I was publishing monthly was stopped in Jan 2018 as I waited for funds to get recategorized as per SEBI guidelines. So after a six-month break, my first task was to choose only those funds that have not changed “much” in nature.

Before we begin: This is the 3rd and final part of the PaisaVaisa Podcast where I talk about how to execute a financial freedom plan. Do give it a listen

I had about 414 funds in the Jan 2018 screener list. This was sorted according to Value Research fund categories. Now I had to remove funds that have changed significantly. Why? Suppose you have a fund that says it will try to point south most of the time. So you look at its history and find out how consistently it has done that. Then one fine day, it announces that it will try and point north. So all that past history of pointing south is now useless. Well, this is not what the screener is trying to do, but hopefully, you get the picture.

With the fund recategorization complete, I was looking for a way to restart the monthly screeners. On 26th June 2018, VR announced it new fund categories and also mentioned the following that instantly caught my eye:

A small number of funds which used to be rated earlier are no longer rated. There are two reasons for this:

  1. Some funds’ basic characteristics have changed. In these cases, the funds will be rated only when they have built up a long enough track-record in their new avatar. This is 18 months for debt funds and 3 years for equity and hybrid funds.

  2. We do not rate categories that are smaller than ten funds as the sample for comparison has to be a certain minimum size. Since, under the new system, there are a larger number of generally smaller categories, many funds which were formerly rated are now in small categories.

So the gears start turning in my head: Hey so all I need to do now is find out which funds have star ratings, get the new categories and then I can restart the past performance screener once again. I assumed that since VR still offers a rating for the fund, then it must not have changed in nature at least in the last three years. This is naturally an easy way out for me as I could not accomplish my task in an automated way. The alternative is pretty impossible – do a manual check. Like elsewhere in life, if we take the easy route, we have to pay the price. So what follows is an account of how I realised the mistake.

If you post every alternate day, you are soon to search for post ideas. So I got the July 2018 screener, decided to make a shortlist so that I can review the fund in detail. Then I demanded that funds benchmarked (by me) to our favourite index – NIfty Next 50 – should have outperformed it over every possible 1Y,2Y,3Y,4Y,5Y period at least 80% of the time. The funds should have also had a better downside protection over every possible 1Y,2Y,3Y,4Y,5Y period at least 80% of the time.

This gave me three funds:

  1. Principal Emerging Bluechip Fund-Direct Plan – Growth Option  (4-star at VR)
  2. Reliance Small Cap Fund-Direct Plan Growth Plan – Growth Option (4-start at VR)
  3. Mirae Asset Emerging Bluechip Fund-Direct Plan – Growth (5-star at VR)

DSP MIcrocap was a close fourth but is not listed because of its recent poor performance (1Y).

Among, these probably Mirae Emerging should be the most recognisable among DIY investors and is currently closed for subscription, other than via SIP. Now, the question is, have these fund changed in character or not? If they have, then the past performance is of no relevance. Therefore, the star rating (which is only based on past performance) is also useless.

Principal Emerging Bluechip Fund

From a fund that could invest between 65-95% in midcaps can now invest bet 35-65% in midcaps. There are many more changes, but that fact alone is enough to recognise that both the past performance and star rating is of no use! It was a mistake to have included this fund (with the best past performance!!) in the screener file. I could the easy route of trusting VR and paid the price for it  – embarrassment.

Reliance Small Cap Fund

As a saving grace, this fund has not changed much in nature. Earlier it merely called itself an open-ended equity scheme but did have small-cap focus and more importantly a small-cap benchmark. It is now an explicit small-cap fund with 65-100% exposure in small-caps. This is reasonable, and the use of the past performance is justified.

Mirae Asset Emerging Bluechip

This fund has changed from one that would invest 65-100% in midcaps to one that will now invest 35-65% in midcaps. Again that alone is enough to ignore past performance and star ratings. The full list of changes is here

I started with a pretty small short-list and two out of those three have to be rejected. sigh! Lesson learnt. Do not make the same mistake I did with your investments! Dig deeper, learn about how the fund will invest. Has it changed recently? If yes, then the past performance does not matter much. In any case, there is that disclaimer! So what is the way forward for the monthly screener? I will have to remove more funds like the above.The gears will have to start working again.

Hey dont forget: This is the 3rd and final part of the PaisaVaisa Podcast where I talk about how to execute a financial freedom plan. Do give it a listen

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About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
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