Why Mutual Fund Ratings Are Not Recommendations to Buy or Sell Funds?

You look at a fund’s 5-star rating. You’re pleased with it and proceed to invest in it because it’s a good fund. You want to invest in a fund, and just filter by the best mutual fund ratings to pick the winners. And why shouldn’t you? A mutual fund gets the top rating because it has performed well! No.

We don’t think that going by ratings to decide that a fund is a buy or a sell is the right approach – even while we have our own mutual fund ratings system Prime Ratings.

How Mutual Funds Are Rated?

Each rating system, whether by Value Research or Morningstar or CRISIL or any other entity, uses its own defined set of metrics. So, a rating system can look at 1-month returns or 6 months, 1 year, or 3 years or any other period.

It can look at the quality of the returns itself, using the range of metrics available to measure performance. For instance, risk-adjusted return measures return generated above the risk-free rate. Standard deviation indicates how much returns fluctuate. Alpha measures returns in excess of benchmark.

A fund will score better on some metrics and worse on others, since the idea behind using such measures is to better understand performance. And yet, performance metrics are derived from one thing only – and that’s a fund’s past returns. A fund’s returns, thus, is the primary dictator of its rating. So what’s wrong, you may ask.

It is that a fund has many qualitative aspects that will not show up by measuring only returns.

• Returns do not adequately capture the risk in a fund until such risk actually materialises.
• Returns or mutual fund ratings do not indicate if the fund is suitable for you to invest in.
• Returns do not capture the potential of a fund’s portfolio.
• Returns do not indicate a fund’s investment style.
• Ratings may not show where the returns came from.
• A rating system built on fund performance cannot identify funds that are at the cusp of changing trends – i.e, good to worsening, poor to improving – without a lag. If such changes did show up quickly in ratings, it will also mean that the rating system is short-term and will frequently see fund ratings dip or rise.

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