Last Updated on August 22, 2022 at 11:12 pm
We received this email from a reader. “Dear pattu sir, I was shocked to see Value Research has rated ICICI Pru Nifty Next 50 Index Fund Direct Plan with their lowest rating of just one star! How is this possible? How can an index fund have a star rating and that too so low? Can you please explain?” Let us try to understand how star ratings work and why ICICI Nifty Next 50 Index fund ended up with only one star!
Let us start with how a mutual fund star rating is calculated. We already have a guide for the layman here. What are mutual fund star ratings (in plain English)? A star rating is a comparison of one fund with another. It does not directly depend on a fund’s performance with a category benchmark like our monthly screeners.
ValueResearch first creates a category of funds to compare. This is the most crucial step in the star rating process and most often the most crucial mistake, as explained below. It then decides on a representative risk-free return (e.g. SBI 45-180 days FD rate).
A risk grade is defined as how often a fund underperformed the risk-free return every month over the last 3Y and 5Y period. In the case of debt funds, a weekly return is used. The category average risk grade is computed, and a “bell curve” of above-average, average and below-average performance are “binned” (a total of 5 segments) as shown below. This logic is identical to how appraisals are done for corporate employees each year, source: VR rating methodology document.
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High | Top 10% |
Above Average | Next 22.5% |
Average | Middle 35% |
Below Average | Next 22.5% |
Low | Bottom 10% |
A return grade is just the opposite. How often the fund has outperformed the risk-free return every month over the last 3Y and 5Y period. An identical bell curve is created.
The star rating is obtained by subtracting the two bell curves to create a new bell curve. VR computes, return grade minus risk grade and make this binning with star ratings as labels.
★★★★★ | Top 10% |
★★★★ | Next 22.5% |
★★★ | Middle 35% |
★★ | Next 22.5% |
★ | Bottom 10% |
When someone gives us an excellent performance appraisal rating at work, do we sit and complain that the process is wrong, arbitrary and unfair? When do we complain? We complain only when things do not go our way when others rate our investment choices as “poor”.
Anyone who has bothered to read how star ratings are assigned would immediately know how arbitrary it is. The fund manager of Axis Bluechip does not use an SBI FD rate as a benchmark. That is not their mandate! The same is true for an index fund.
As I have mentioned several times before, index investing only became popular because of visible outperformance over the last few years. First, it was Nifty Next 50 in 2016,17 and then Nifty and Sensex.
ICICI Nifty Next 50 Index Fund was a five star rated fund in 2018 (when the index had already started to fall). This picture is dated Feb 2020, taken from Are Indian Investors ready to choose Index mutual funds or ETFs?
Star ratings are based on past performance, and since it is based on 3Y and 5Y windows, it will take a long time to react! By which time, lazy investors would have started investing. The Nifty Next 50 index started falling from Feb 2018, and so did the star rating of this fund. From 5 –> 4 –> 3 –>2 and 1.
When a fund’s rating is five stars, no one bothers to ask how it is computed. VR puts together Nifty, Sensex, Nifty 100, Nifty Next 50, Nifty Equal-weight 50 and 100, Bharat 22 ETF, low volatility ETF, index funds, active large cap funds and four focused funds in the same “large cap” category and rates them. And readers may recall we have shown several times that the Nifty Next 50 index is not a large cap index. It is a midcap index cap (never mind what SEBI says, we go by facts around here).
This VR categorization is like grouping apples, tomatoes, capsicums, strawberries, cherries, pomegranates and chillies together because they all look red.
Even a casual observer will know that the NIfty Next 50 has underperformed relative to Nifty/Sensex for more than three years. Hence the low star rating. The Nifty Next 50 index will obviously have a lower return grade!
Is this kind of star rating for an index fund, right? Of course, it is correct from the standpoint of those who award it. Star rating is a relative grading given by comparing one fund to another. What is wrong is, investors taking it seriously!
Should I continue investing in ICICI Nifty Next 50 index fund? That depends on why you chose the fund. If you selected it because of its five stars, then nothing will satisfy you. Star ratings will go up and down every month. If you picked it with a plan in mind, either stick to that plan or get that plan reviewed by a SEBI registered fee-only advisor. A star rating is the last thing to use while choosing a mutual fund – active or passively managed.