Relying on Star Ratings to Pick Best Mutual Funds? Read This

November 25, 2023 Mutual Fund

The investor-wise composition of Indian mutual fund assets shows that individual investors (retail + HNIs) now hold a higher share (58.9% in October 2023) than institutional investors. And a majority of individual assets (89%) are held in equity-oriented mutual fund schemes.

While these are very encouraging data points showing that investors are taking high risks in the pursuit of earning better returns than some of the traditional investment avenues, what is concerning is the approach followed to pick the best mutual funds.

A majority of individual investors look at mutual fund star ratings — go with high-rated 4 or 5-star ratings — to choose mutual funds, hoping that they would reward them and help accomplish financial goals.

However, one cannot solely rely on mutual fund star ratings, as they may not be foolproof. Watch this video where my colleague, Vivek Chaurasia, in conversation with our Founder of PersonalFN, Ajit Dayal, exposes the flaws of the popular star ratings given by certain agencies/organisations.

You cannot blindly trust the star ratings of mutual funds. You see, most of these ratings are given based on quantitative parameters, mainly historical returns, which may or may not be sustainable in the future.

It’s possible that the 4 or 5-star rated fund that you added to your portfolio today may lose some of its stars (the sheen) if its performance lags in the future. This is why many investors witness their mutual fund portfolio underperforming over time.

[Read: The Reasons Behind Mutual Fund Underperformance – A Comprehensive Analysis]

Keep in mind that mutual fund star ratings say nothing about the future potential of the fund. Relying on star ratings given on historical performance is akin to driving a car looking mostly in the rear-view mirror, which could result in a disaster.

Do note that most websites that rate mutual funds either don’t follow a comprehensive methodology or conduct extensive research. They largely rely on historical quantitative data, mainly the returns and few risk ratios, instead of looking at the qualitative aspects of the scheme.

Ask yourself how can you have faith in the past and inconsistent performance of mutual funds when you are planning for your financial future.

Besides, there are chances that the top-rated mutual fund schemes by an agency are, in fact, sponsored advertisements that some fund houses/brokers pay to promote a particular scheme.

What you need is to follow a prudent approach to invest in the best mutual funds rather than relying on surface-level ratings or rankings.

At PersonalFN, when we approach mutual funds to recommend our subscribers, we follow a comprehensive approach considering a host of quantitative parameters (returns across time periods, risk ratios, performance across asset cycles, evaluate the proportion of AUM actually performing) and qualitative parameters (portfolio characteristics, the experience of the fund manager, the funds-to-fund manager ratio, the investment ideologies of the fund house, and whether there are robust investment processes and systems followed at the mutual fund house). All of this is sort of encapsulated in PersonalFN’s SMART Score Matrix.

(% are weights given to each of the parameters in PersonalFN’s SMART Score Matrix) 

We zero in on mutual funds on these 5 key variables and not just the returns. In fact, as you can see in the table here, performance track record is the last thing we consider.

The most fundamental thing we look at to evaluate mutual funds is the Systems and Processes (S) at the fund house aspects such as the philosophy of the fund house, whether the fund house is a mere asset gatherer or a prudent asset manager (to understand the efficiency in managing the investors’ hard-earned money), the average experience of the fund manager, the fund manager-to-schemes ratio, ethics and standards, and fund management process and systems in place.

The next we look at is the Market Cycle Performance (M) of the mutual fund scheme under consideration. Meaning, we assess how the scheme has fared against its peers and benchmark across market cycles, i.e., bull and bear phases.

During bullish phases, most equity mutual fund schemes would do well and outperform the benchmark, but the true test that separates the men from the boys is the bear phase. A well-managed equity fund would demonstrate its ability to manage the downside risk better. Simply put, it would fall less than its peers and benchmark. So, Market Cycle Performance (M) shall expose the true nature of the fund. Note, mutual fund schemes that score high on this parameter are usually stable and reliable.

We also try to assess the Asset Management Style (A) , wherein the mandate and strategy of the fund are considered. So, typically, we look at the portfolio characteristics, whether the fund pursues a value or a growth style or a blend of the two, the P/E of the underlying portfolio, the dividend yield of the portfolio, the weightage of top 10 holdings in the portfolio (highlighting the concentration risk), the weightage of top 5 sectors the fund has exposure to, the portfolio turnover (to understand whether the fund manager churns the portfolio too often or holds it with convictions), the expense ratio, and so on. This varies from fund to fund, and let me tell you, the Asset Management Style (A) could make a significant difference in returns over the long term. We also try to evaluate whether the fund is really sticking to its investment mandate in the endeavour to achieve its investment objective.

Given that for every level of return, there is a certain level of risk, we also evaluate the Risk-Reward Ratios (R) of mutual fund schemes. In fact, the impact of the Asset Management Style (A) of the fund becomes clearly visible in the risk-reward ratios. So, typically, we look at the Standard Deviation, Sharpe Ratio, Sortino Ratio, Treynor Ratio, and so on.

[Read: 7 Ratios to Assess Mutual Fund Risk And Identify the Best Mutual Funds]

“The essence of investment management is the management of risks, not the management of returns,” said Benjamin Graham. We follow this principle to recommend the best mutual fund schemes. We are conscious of the risk a mutual fund scheme exposes its investors to depending on its category and sub-category. This gives us a good idea of whether the excess returns of the mutual fund are coming in because of higher risk or prudent portfolio characteristics. We prefer mutual funds that offer competitive or appealing returns with lower risk.

The last in our SMART Score Matrix to evaluate mutual funds is Performance Track Record (T) . Here, the historical performance is considered. This ensures that all the subjective analysis we did earlier is ultimately translating into better returns for investors.

We evaluate the track record across various time frames as opposed to returns over one or few time periods, and that too on a rolling return basis (6-month rolling, 1 year, 3 years, 5 years, and risk-adjusted returns). Rolling returns provide a realistic picture of the performance, eliminate the risk of recency bias, sort of evens out on the lop-sided on account of higher volatility, capture returns across market phases, measure the consistency in returns, and throw light on the value added by the fund manager.

[Read: All You Need to Know About the Rolling Returns of Mutual Funds]

This holistic approach of a SMART Score Matrix ensures nothing is left to luck or chances and helps us identify schemes that have the potential to stand the test of time.

To pick winning mutual fund schemes from a plethora, what you need is a sensible and prudent approach.

Also, make sure you are adding not just the best but suitable mutual fund schemes to your portfolio, considering your personal risk appetite, broader investment objective, financial goals, and the time in hand to achieve those goals (or investment horizon) – rather than simply following what friends, relatives, colleagues, or neighbours with do with their investments. Remember, investing is an individualistic exercise. One man’s meat is another man’s poison.

Be a thoughtful investor.

Happy Investing!

This article first appeared on PersonalFN here