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?

Join our 1500+ Facebook Group on Portfolio Management! Losing sleep over the market crash? Don't! You can now reduce fear, doubt and uncertainty while investing for your financial goals! Sign up for our lectures on goal-based portfolio management and join our exclusive Facebook Community. The 1st lecture is free! Did you miss out on the lockdown discount? You can still avail it! Follow instructions in the above link!

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.

Do share if you found this useful
Share your thoughts on this topic at the  Reddit freefincal_user_forum

Reach your financial goals like a pro! Join our 1600+ Facebook Group on Portfolio Management! You can now reduce fear, doubt and uncertainty while investing for your financial goals! Sign up for our lectures on goal-based portfolio management and join our exclusive Facebook Community. The 1st lecture is free!
Want to check if the market is overvalued or undervalued? Use our market valuation tool (will work with any index!) or you buy the new Tactical Buy/Sell timing tool!
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
About freefincal & its content policy Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on developments in mutual funds, stocks, investing, retirement and personal finance. We do so without conflict of interest and bias. We operate in a non-profit manner. All revenue is used only for expenses and for the future growth of the site. Follow us on Google News Freefincal serves more than one million readers a year (2.5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication. Freefincal does not publish any kind of paid articles, promotions or PR, satire or opinions without data. All opinions presented will only be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions, seek the right answers and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now. It is also available in Kindle format.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at low cost! Get it or gift it to a young earner

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is a deep dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, how travelling slowly is better financially and psychologically with links to the web pages and hand-holding at every step. Get the pdf for Rs 199 (instant download)
Free android apps