Why star ratings should not be used for selecting debt funds!

Here is why investors should not use mutual fund star ratings for selecting debt funds. When all risks are not factored in, the result would be misleading and expensive!

Published on / By M. Pattabiraman Twitter: @pattufreefincal / 3 Comments

Published: January 18, 2020 at 11:58 am

Last Updated on January 18, 2020 at 11:58 am

The Vodafone Idea bond crisis has once again highlighted the importance of risk awareness in debt mutual funds. Here is why investors should avoid using mutual fund star ratings for at least debt mutual funds!

While this article was being written Value Research has a “Rating Suspended” message instead of the five/four-star rating that it had for Franklin Ultra Short Bond that fell 4% on 16th Jan.  It took the rating portal so many credit events to finally learn that something is wrong with their method. Regular readers may be aware that we have been pointing this out time and time again: Mutual Fund Star Ratings are Flawed, but Investors are to blame for taking them at face value.

To understand why star ratings should not be used for debt funds (well, all funds, but at least debt to begin with), we must recognise what they are and how they are computed. This is a simple introduction: What are mutual fund star ratings (in plain English)?

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Any financial instrument has visible risks and invisible risks. Investors make the mistake of assuming that visible risks are the only risks. For example, price or NAV moving up and down is a visible risk. In an equity fund, this is a daily occurrence.

The price for a small cap stock or fund moves up and down more than a large cap fund and we say small caps are riskier than large caps. Inflation is an invisible risk. Corporate governance is an invisible risk. Creditworthiness is an invisible risk.

An invisible risk here means we do not realise its presence until it strikes, leaving us in shock. If fraud is detected in a company, the price drops sharply. When it happens in a large cap, the shock is that much more.

It is crucial for investors to recognise that star rating methodology cannot account for invisible risks. It can only work with visible risks.

The most important invisible risk when it comes to debt funds is the credit rating. A bond rated AA is not as robust as one with AAA. Therefore to compensate for this lower repaying ability the AA bond should offer more interest rate.

This is counterintuitive when we think about it. We demand more interest from a borrower who has a lower repaying capacity (as estimated by the rating agency)! When the debt becomes too high and there are not enough profits to pay interest, there is a debt snowball the soon the company heads for default.

A mutual fund holding only AAA bonds (in the absence of a credit event) will produce lower returns than a fund holding only AA bonds. If there is no default or delay in interest payment, the NAV of both funds will keep moving up (with small fluctuations due to demand and supply variations).

For the rating algorithm, this means the AA-fund has given more return than the AAA-fund over the same period for comparable risk (measured only in terms of NAV ups and downs). Thus the AA-fund gets a higher star rating than the AAA-fund

A lazy investor who looks only at the star rating blindly invests in the AA-fund assuming “the experts say this is a better fund, so let me go with this”. Then they blame the rating portals and associated “experts” for the “wrong rating”.

All parties are at fault here – the rating portals, the investors and advisors too (who rely on the ratings!) Investors must ignore star rating and understand how to measure debt fund risk.

Debt mutual fund risk parameters

  1. Yield to maturity. Higher the value, higher the credit risk (not returns!!)
  2. Average portfolio maturity: Higher the value, higher the NAV fluctuations
  3. Modified duration/Macaulay Duration: Higher the value higher the NAV fluctuations

The problem here is, higher the yield to maturity, higher will be the star rating in the absence of credit events. For short-term goals, investors should stick to an average portfolio maturity of a few and low yield to maturities. This means overnight funds, liquid funds, money market funds and ultra-short funds. The credit quality history should be checked with fund factsheets before and after investing.

Resources to help investors choose debt mutual funds