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:

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  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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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.
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  1. I would like to share the story of two investors, who did investment in mutual fund as Lumpsum. Let be name as A & B.

    A & B decided to invest 3lacs in mutual fund in the month of June’15, regardless target, time, goal,etc., They both approached the same financial advisor , who is not fee- only category.
    Advisor recommended both to invest in the NFO which has launched that time.
    So, A – decided to put his entire amount in NFO ( Reliance retirement fund – Income generation – Growth – per unit rate is Rs.10/- ).
    Whereas, B not followed the financial advisor advise and asked him to select 10 schemes and picked 6 funds ( based on past returns & checked the various sites star rating, etc., ) and to put 50 k on each ( 1. Axis long term equity fund -R-G, 2) Canara robeco emerging equities -R-G, 3)DSPBR small cap- R-G, 4) Franklin India Smaller companies fund -R-G , 5)UTI Transport & Logistic fund-R-G, 6 )UTI Equity -R-G.

    They forgot this investment for 3 years and in June 2018, both checked their current fund value.
    Person A got shocked, when he saw his fund value ( it didn’t gave even FD returns ) and person B is happy with his fund value ( he added all funds and calculated the average returns and it gave 12 -15 % returns).

    Now, tell me who is the wise person.

    In this point of view, I shared some of my regrets with fee only advisors.
    First of all , they will ask so many questions & details like goal, tenure,before providing their advise.
    Secondly, they won’t recommend more than 2 funds for this type of small amount.
    Thirdly, In case if we followed even their two funds recommendation, not performed after 2nd 3 years, who will absorb the losses, obviously the investor only.Instead of that, we can invest in more funds and average the risk.
    Fee only advisors have their own thumb rule ( like one should not have more than five funds only like our hand )
    While selecting more funds, may be sectors overlapping will be there.
    For instance, if we found banking sectors fund will give more returns in future and we selected any one fund which has banking stocks.
    My point is, not all banks stocks will give good returns. May be HDFC & ICICI bank fund performed better than SBI.
    Instead of selected only one fund which holds SBI, rather select two or three funds which holds all these three banks stocks. Might be got average more returns

    I know my statement is not that much technical and grammatical way, If you want – please modify in your way.

  2. @PattuSir – Congrats Sir, They say that success of an online product( like Facebook, Gmail etc) is measured by the volume of spam traffic. If there is more spam then it means product is a success wrt to its reach and adoption. And hence by that metric your posts on fee-only mode of financial planning seems to have spooked the fee-based/commission based fans who have now started to use your own platform to try and show the fee-only planning in bad light.

    @Raajesh Kannan – This is an anecdotal argument, with many (incorrect) assumptions. You are operating with a prejudice that fee-only planners will not understand your goals better and will suggest 1 fund with zero diversification. I am not sure if that is the right way to summarize the merits of fee-only planners.

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