Here is why you should ignore mutual fund star ratings

Published: October 4, 2014 at 7:00 am

Last Updated on

‘Should I choose only five star rated mutual funds?’, ‘Should I switch funds each time my funds rating is downgraded?’. These are extremely common questions among mutual fund investors.  In this post, let us discuss how star fund ratings are irrelevant to the goal-based investor.

Any action, buy, sell, hold, switch etc. should be based on observations with respect to meaningful reference point.

Understanding this is key to successful investing, be it in stocks or mutual funds of fixed deposits.

There is nothing wrong with star ratings. They are based on solid math and forms the core of all quantitative mutual fund analysis.

However, it is important to recognise that we are investors and not analysts. An analyst has no choice but to relatively grade mutual funds and award them stars.

mutual-fund-star-rating

Only the listless investor would worry about the relative performance of his/her holding wrt to all the funds in that category.

Any investor should first have a clear idea of how much to expect from a particular fund category (and not from the fund). The expectation should be reasonable. They must understand what a standard deviation is and how much returns can typically deviate from the expected value for a given time period.

See this for more details: How to select mutual fund categories suitable for your financial goals?

For example, no fund can satisfy an investor who wants 25% annual returns.  A good 80% of funds in each category can satisfy investors if they only want average 10% return over the long-term – the recommended long-term return expectation from equity.

See: Understanding the nature of stock market returns

and How important is mutual fund selection?

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As long the as the CAGR of the holdings (not the recent CAGR of fund) is higher than the expectation, there is absolutely no reason to change funds.

Even if the CAGR of the holdings drop below expectations, one will need to qualitatively analyze the state of the market, the stance of the fund manager, when the money is needed, and then, and only then, take appropriate actions.

If the fund has a good track record, the fund manager has not changed, the content of its portfolio not deviated too much wrt its investment mandate, nine times out of ten, there is no need to immediately change the fund even if it returns lower than expectations, if the goal is far away (my HDFC Equity holdings CAGR was 4% last November. Today it is 32%. It is tagged to my retirement goal).

It may so happen that a fund which was returning 5% more than our expectation suddenly dropped to only 2% more. In such case, the consistency of the funds performance with respect to its benchmark should be evaluated.

See:

Multi-index rolling returns analyzer  to evaluate consistency of performance.

Mutual Fund Risk and Return analyser – to understand the importance of risk adjusted return. You can consider abandoning the star ratings and use this instead 🙂

As long the fund is out-performing the benchmark over 3 years or so, I see no reason to change the fund.

Therefore, a funds star rating is not relevant at all to the goal-based investor.  Even those who mindlessly chase after returns, ‘just like that’, have a goal (of some sort!). So star ratings won’t help them either. That nothing would them help, is another matter altogether!

Bottom line: Learn about risk-adjusted return, how to evaluate consistency in funds performance or seek professional help … and pray that the professional does not rely on star ratings!!! Sadly too many of them do.

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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.
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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10 Comments

  1. I follow Investors guide on ET Now on every weekend where Mr. Dhirendra Kumar will be the guest. He himself told many that some good funds like HDFC Top 200, ICICI Pru focused, Franklin India Blue Chip need not necessarily be 5 rated all the times. We follow Quantitative analysis to rate the funds and a star slip doesn’t necessarily need any attention or panic. Keep Calm and continue Investing 🙂 Thanks Pattu sir for another good article !!!

  2. I follow Investors guide on ET Now on every weekend where Mr. Dhirendra Kumar will be the guest. He himself told many that some good funds like HDFC Top 200, ICICI Pru focused, Franklin India Blue Chip need not necessarily be 5 rated all the times. We follow Quantitative analysis to rate the funds and a star slip doesn’t necessarily need any attention or panic. Keep Calm and continue Investing 🙂 Thanks Pattu sir for another good article !!!

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