The Trouble With Mutual Fund Star Ratings

Mutual fund star ratings are supposed to rate funds on a risk adjusted basis. That is, more the number of stars, better the risk-adjusted performance. If you look at some of the metrics they use to award star ratings, you might agree with me that this is not as easy as it sounds and that the 'best' funds need not necessarily carry five stars.

First some simple definitions

1. Beta  is a volatility measure and tell us how much the fund changes for a given change in the index. A beta of 1 implies the fund movement is identical to the index movement. A beta of 0.9 implies the fund is 10% less volatile than the index.

Lower the beta, lower the volatility

2. Standard deviation is a volatility measure and tell us, for a given set of returns (daily returns in this case), how much do individual returns deviate from the average. This is calculated for both the fund and the benchmark.

Lower the standard deviation, lower the volatility

3. Alpha  is a risk adjusted performance measure. It takes into account, the average return of the fund and its benchmark, a risk-free rate defined by the user and how the fund responds to swing in the benchmark (Beta)

Higher the alpha, higher the outperformance of the fund.

4. Sharpe ratio  is a risk adjusted performance measure. We calculate the excess returns of the fund wrt a risk-free rate. The ratio is the average of the excess return and the standard deviation of the excess return. This is calculated for both the fund and the benchmark.

Higher the Sharpe ratio, better is the performance (higher returns + low deviation from average return)

5. Sortino Ratio  is a risk adjusted performance measure. The Sharpe ratio considers both positive and negative excess returns (wrt risk free rate). The Sortino ratio considers only the negative excess returns while calculating the standard deviation. There should be enough negative excess return data points to justify the use of the Sortino ratio. To take care of this, daily returns are used (instead of monthly returns as done by AMCs/fund portals).

Higher the Sortino ratio, better is the performance (higher returns + low negative deviation from average return)

The next step is to understand that these metrics are not independent

The following is based on data for all equity funds, except sector funds from Value Research online. The metrics are computed over a 3 year period.

risk-vs-reward-star-ratings-1

Higher the standard deviation, higher the beta, typically.

risk-vs-reward-star-ratings-2

Higher the Sharpe ratio, higher the Sortino ratio, typically.

risk-vs-reward-star-ratings-3

Higher the Sharpe ratio, higher the alpha, again typically.

Now let us look at these metrics wrt star ratings

Standard deviation vs. Star Ratings

risk-vs-reward-star-ratings-4

Try to ignore the red box first! Notice that several one star funds have comparable standard deviation with 5 star funds.

The red box is a filter. It aims to filter funds that have a standard deviation no higher than 5 star funds. About 20%. All funds above this box are eliminated for risk vs. reward analysis (see below).

Sharpe Ratio vs. Star Ratings

risk-vs-reward-star-ratings-5

About 50% of two star funds have comparable Sharpe ratios with five star funds. The red box this time eliminates all funds which have Sharpe ratio below five star funds. That is, all points below the box are eliminated for risk-vs. reward analysis.

3-year return vs. Star ratings (filtered)

After applying both red box filters mentioned above, the 3-year return vs. star ratings is shown below.

risk-vs-reward-star-ratings-6

There is one 1-star fund and several 2-star funds that have a risk-adjusted profile similar to 5 star funds!

3-year Alpha vs. Star ratings (filtered)

After applying both red box filters mentioned above, the 3-year alpha vs. star ratings is shown below.

risk-vs-reward-star-ratings-7

Again, the conclusions are the same as the above graph.

Risk vs. Reward (full data set)

Return (reward) vs. risk (standard deviation) for the full data set. There is no correlation. Higher risk does not mean higher reward!

risk-vs-reward-star-ratings-8

 

Risk vs. Reward (filtered)

Return (reward) vs. risk (standard deviation) for the data set filtered with two red boxes (no standard deviation more than 5 star funds, no Sharpe ratio less than a 5 star fund). Now the correlation has improved (the data bunch slopes up) but it is still quite poor.

risk-vs-reward-star-ratings-9

Risk vs. Reward (3,4 and 5 star funds only)

Return (reward) vs. risk (standard deviation) for all funds except 1-star and 2-star funds. The correlation is still poor. More stars does not necessarily mean better risk adjusted performance.

risk-vs-reward-star-ratings-10

Sharpe Ratio vs. Star Ratings (a new filter)

Let us now try another kind of filer. Let us now push the red box up and eliminate all funds which  have a Sharpe ratio lower than the highest value observed for a 2-star fund.  That is all points below the box are eliminated. This means eliminating most 3-star funds, many 4-star funds and a handful of 5-star funds.

risk-vs-reward-star-ratings-11

Risk vs. Reward (with the new filter)

Notice now that the correlation between risk and reward has improved after eliminating some 3,4 and 5 star funds. This is only 28% of the full data set!

risk-vs-reward-star-ratings-12

I am not proposing a method of correlating risk and reward. The indisputable truth is that they cannot be correlated.

The point I am trying to make is,

do not assume, higher star rating implies better risk adjusted performance.

So I choose to not depend on star ratings at all. I prefer to focus on long-term consistent performance.

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41 thoughts on “The Trouble With Mutual Fund Star Ratings

  1. N S Raghavan

    Dear Pattu, Article and analysis well researched and written, Kudos as always, Trust Pattu to come up with something radical, which others overlook. Suppose we ignore the star ratings completely, what is the alternative process to evaluate a fund in relation to other comparable funds in the same segment, and how does one then build a portfolio of funds to meet long term financial goals. Please advise

    Reply
  2. N S Raghavan

    Dear Pattu, Article and analysis well researched and written, Kudos as always, Trust Pattu to come up with something radical, which others overlook. Suppose we ignore the star ratings completely, what is the alternative process to evaluate a fund in relation to other comparable funds in the same segment, and how does one then build a portfolio of funds to meet long term financial goals. Please advise

    Reply
  3. gaurang

    Dear Sir
    So Good article , but new mf investor how can asset allocation in invest pure equity base construct portfolio so plz advice it. god bless you

    Reply
  4. gaurang

    Dear Sir
    So Good article , but new mf investor how can asset allocation in invest pure equity base construct portfolio so plz advice it. god bless you

    Reply
  5. moronbuffett

    quote: So I choose to not depend on star ratings at all. I prefer to focus on long-term consistent performance

    read it 10x times faster: mutual fund investments are subject to market risk. past performances do not guarantee future returns

    " there are lies, damn lies and statistics" - mark twain

    Reply
    1. freefincal

      That disclaimer is true for star ratings as well. I operate on the belief that a fund management which has performed well through the ups and downs of the market has a decent chance of navigating in the future. I dont think much of Twains quotes on statistics. I dont think he was formally trained in it.

      Reply
      1. moronbuffett

        tacit assumption: a fund manager (not fund management) who has performed well through the ups and downs in the past will still remain with the same AMC for the next decade or so!

        Reply
        1. freefincal

          Not tacit at all. Which is why I said management and not manager. There are funds which have done well irrespective of who has managed it. There are only so many things one can worry about and I draw the line here. I had shown in an earlier post that there is decent correlation between the past and future performance. That is good enough for me.

          Reply
  6. moronbuffett

    quote: So I choose to not depend on star ratings at all. I prefer to focus on long-term consistent performance

    read it 10x times faster: mutual fund investments are subject to market risk. past performances do not guarantee future returns

    " there are lies, damn lies and statistics" - mark twain

    Reply
    1. freefincal

      That disclaimer is true for star ratings as well. I operate on the belief that a fund management which has performed well through the ups and downs of the market has a decent chance of navigating in the future. I dont think much of Twains quotes on statistics. I dont think he was formally trained in it.

      Reply
      1. moronbuffett

        tacit assumption: a fund manager (not fund management) who has performed well through the ups and downs in the past will still remain with the same AMC for the next decade or so!

        Reply
        1. freefincal

          Not tacit at all. Which is why I said management and not manager. There are funds which have done well irrespective of who has managed it. There are only so many things one can worry about and I draw the line here. I had shown in an earlier post that there is decent correlation between the past and future performance. That is good enough for me.

          Reply
  7. Mitesh

    Really interesting! If I try to prioritize these ratios and come with a composite score, will it still avoid the biasness?

    Reply
  8. Mitesh

    Really interesting! If I try to prioritize these ratios and come with a composite score, will it still avoid the biasness?

    Reply
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  11. Abhijeet

    Star ratings are over hyped concept, a standard which became too popular only because uninformed investors will be totally clueless without these ratings.

    Reply
  12. Abhijeet

    Star ratings are over hyped concept, a standard which became too popular only because uninformed investors will be totally clueless without these ratings.

    Reply

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