I find that my mutual funds star rating has dropped. It is time for me to switch? When should I change funds? These are questions I am sure every mutual fund investor must have asked these and related questions at some point or the other.
The following post is about performance review of equity mutual funds. Exiting instruments based on proximity to financial goals is a different ball game which depends on the nature of the goal. See this for a post on the topic.
If you search online about exiting mutual funds, you will find statements like these (perhaps from freefincal too!)
Change funds if,
1) the fund is not able to beat the benchmark over 3 or 5 years.
2) the dip in performance is linked to a change in fund manager
3) or due to a sudden increase in AUM
4) if the fund has deviated from its mandate
5) the rating has dropped below 4 stars etc.
A while back I had written on how to review a mutual fund portfolio
In this, I had mentioned that a review needs a benchmark and a natural benchmark (imo) is the net XIRR* of the equity (or debt) folio.
This number immediately tells me which funds have outperformed this 'average' and which have not.
For example, I was holding units of my last ELSS fund Canara Robeco Tax Saver until a few months ago. My net XIRR for retirement hovered around 22-23%. I had funds which outperformed this by quite a bit.
The Can Robeco fund refused to budge beyond 11-12% and I have had it for more than 3 years. It was not providing my portfolio anything special in terms of diversification. So I chucked it. This improved my net XIRR.
All my other funds have not very different returns. So I am not inclined to do anything about them. This includes HDFC Top 200 - the topic of (yet another) long thread at FB group Asan Ideas For Wealth.
HDFC Top 200's performance has dropped. Should I get rid of it?
Regular readers maybe aware of a previous post (Sep. 2013) on the topic: Do It Yourself Mutual Fund Analysis: HDFC Top 200 Fund
Now let us look at this from the point of view of star ratings. I am no fan of star ratings (see why here (part 1) and here (part 2)), but many are. They see it is a simple way of finding out how their fund is performing relative to its peers.
I am no fan of relative grading. I think it is like smelling the aroma from your neighbors kitchen and assuming dinner is ready. I do it for a living at IITM and I notice that often kids who do poorly compared to other classmates, do extremely well for themselves given enough time and space.
Star ratings are for analysts. Once I invest in the fund, I must have a method in place to review performance.
If it has to be based on star ratings, there must be a solid method behind that.
It is all well to talk about checking for style purity, consistency etc. Truth is, very few people are inclined to do this.
Either by accident, or when they decide to review their folio holding, they see star ratings and hope to see 5 stars tagged to their funds. If the rating has dropped to 4 stars, there is apprehension. If it has dropped one more star ....
To those who love star ratings I ask, more than one portal offers such ratings and at any given time, the same fund will be rated differently.
How will you decide which portal to choose? Will you choose VR online because that is what Google coughs up first? Will you choose it because it looks easy to navigate and pleasing to the eye or because the star rating is in a bright red?
If you put a gun to my head and ask me to follow a star ratings portal, I will go by what Morning Star offers. Because:
- A clear ranking methodology document is available. I can use to rank funds on my own if I had the analytics. VR online has a page on this but it is of not much use, except that they combine 3Y and 5Y analysis for the rankings.
- Have separate 3Y, 5Y and 10Y ratings with risk and return grades (see below).
- They clearly mention the durations over which risk and return metrics are computed. VR online does not and does not bother to clarify when queried.
- They have independent analysts ranking (qualitative rankings) along with star ratings (quantitative rankings) for many funds. This gives me better perspective. HDFC T2oo is 3* according to VR but 4* with a gold analyst ranking. How about that?
The point is, every portal has its own set of criterion. Definitions of fund categories vary from portal to portal. A large cap fund in one will be found in large+mid cap category in another. The rating agency is no doubt being internally consistent.
However, how can we, the investors, decide which is the best, or at least the most desirable to follow?
Since I don't know how to answer this, and since there is no gun to my head, I choose not to follow any star ratings but do follow other metrics from MorningStar.
I also have a risk and return analyzer based on the past 1,2,3...8 Y investment durations and use it while choosing funds and if I have want to evaluate performance.
Analytics maybe free from subjectivity, choice of analytical tools and sources is not!
If you wish to follow star ratings for mutual fund selection and performance review, then here are some considerations for you.
1. Track fund ratings. VR online updates ratings each month (guess first week), don't know about Morning Star (probably the same).
Each month, copy the entire ratings lists and save them. Whenever you review your mutual funds ( once a year will do), you will know when your fund dropped or gained in ratings.
If you wish to switch, you can consider switching to a fund which has held 5 stars for a while (sometimes the VR reviews mention this).
It may so happen that ratings of funds that you have switched to may drop the next month. This may be because the sample size got bigger and more funds got added! That is the problem with the relative grading!
That is a chance you will have to take.
You may also bet on a fund which has recently been awarded 5 stars in the hope that it will remain so at least for few months to come. That is again a chance you will have to take.
You can also leave alone funds which have just dropped to 4 stars or even switch from a 3 star fund to a 4 star fund if you liked it.
In all fairness, looking for consistent performance without using star ratings also amounts to taking a chance. It is a question of which method makes you comfortable.
Again subjectivity at work!
I don't like relative grading period, and I hate it in the case of mutual funds when the sample size increases each month. I don't like consistent performers downgraded because of relatively new funds.
Many funds that existed before 2008 crash have been beaten by those which were started during or after the crash. I am not sure if that it is a good idea to downgrade with a solid history of consistent performers because of a few young Turks!
One could argue that investors deserve to invest in the 'best' funds. I think 'best' ought to be a personalized benchmark (like net XIRR) rather than a relative one. This will, in my opinion, be more stable and cut some slack for funds.
The trouble with star ratings is that it can increase investor stress and could lead to hasty decisions.
Star ratings history will give you better perspective (see below). A month by month history is not readily available and must be created. If not month by month, at a quarterly frequency.
All said and done, having a solid method based on star ratings is any day better than asking for best fund names in a forum.
Irresponsible bloggers help promote the 'best fund' culture by writing posts such as top best 15 funds for year xxxx, because the words top and best are popular keywords so can help generate traffic and Google Adsense clicks!
2. Decide on your comfort zone
What is the lowest star rating that you can stomach? It is 4 star or 3 star? To understand this, have a look at the distribution of fund ratings. This is from Morning Star. VR online also has a similar distribution.
Notice that that 3 star funds are the fattest. The no of 4 star + 5 star funds is lower than the no of 3 star funds.
At any give point in time, fund which are to the right of centre, that is 50%, would have beat the average category returns and have a risk grade better than the average (risk and return follow different distributions). Almost all such funds would have beat their benchmarks.
It is possible for 3 star fund to have beat the category average as well as benchmark.
HDFC Top 200 has, year after year for the last 10 Y (possibly more), beat its benchmark (BSE 200) and category average.
This means, it has pretty much always remained to the right of the yellow line in the above distribution. To me that sounds like a pretty good fund. Just like sports, form is temporary but class is evident.
This performance refers to the returns distribution. There is a risk grade distribution which is similar in shape.
Have a look at HDFC Top 200 risk and ratings history at Morning Star.
The relative return has never dropped below average. Actual nos are better than this (see the history tab). However the risk rating has increased. Meaning, the fund is not returning enough for the risk that it is taking. Notice the perspective ratings history offers.
If that is not good enough for you is something only you can decide. Personally I am happy with funds which are to the right of the yellow line on any given year. This relaxed criterion is more than enough to meet my financial objectives. It keeps me calmer.
At the end of the day, when you want money for your goals, the XIRR will not matter. Only how much you have.
Is it wise for investors to want to select and hold funds which in the top 32.5% (4* or 5*) of each category at any given point in time?
I am not so sure. When the selection criterion narrows, it will more often than not lead to increased stress and desire to shift funds too frequently. But then again, it takes all kinds to make a world.