The Top Blunder in Mutual Fund Investing and How to Sidestep Them

December 30, 2023 Mutual Fund

Many mutual fund investors unknowingly make a significant blunder or mistake – relying excessively on star ratings. These seemingly innocent stars, ranging from one to five, promise simplicity and quick evaluation but can mislead investors into making wrong decisions.

While star ratings attract investors with the allure of an easy shortcut to identifying successful mutual funds, they are derived mainly from past performance data, providing only a snapshot of a fund’s historical performance, and may not accurately forecast the unpredictable future.

Unlike picking a restaurant based on ratings and customer reviews on the food quality and service, mutual fund investing involves not just the present but the unknown future, and past success does not guarantee future returns. Notably, the fund’s past performance may have been influenced by countless factors, and what worked in the past may not certainly work in the future. Thus, reliance on mutual fund star ratings can lead to financial missteps.

While investing in mutual funds, it is crucial to understand the reasons behind the fund’s past performance, recognise its pitfalls, and adopt a more informed and strategic approach to mutual fund investing.

So, let’s understand the reasons behind the magnetic pull of star ratings and explore why investors are drawn to them as a quick and easy evaluation method.

The Allure of Star Ratings

Think of star ratings as a guide in the world of mutual fund investing. Imagine scrolling through investment opportunities and finding a fund with a five-star rating – it seems promising.

The main purpose of mutual fund star ratings is to simplify decisions by providing a shortcut to identify potential winners. But can all highly-rated funds be winners in the future? That’s a question we need to answer.

A further evaluation beyond star ratings may show that a high-rated fund does not guarantee success, and a lower-rated one could perform unexpectedly well in the future.

Consider encountering a fund with five-star ratings due to its past superior performance. However, stars only tell part of the story, neglecting crucial factors like luck and timing.

To illustrate, think of a cricket team that won the previous World Cup. Would you automatically bet on them for the next one? Probably not. Mutual funds operate with similar unpredictability, with only a few consistently topping returns.

A fund’s success may be due to favourable conditions, like a booming sector or some of the evolving stock bets. But if conditions change, relying on stars can be misleading.

In this exclusive video, our head of research Vivek Chaurasia explains why investing in 5-star rated funds may not be the best investment decision. Watch the video now!

Stars fail to convey the detailed story behind a fund’s success. To make informed decisions, understanding this backstory is crucial. After all, you wouldn’t commit your money without knowing the positives and negatives.

In essence, while star ratings grab attention, they are just like covers to the book of mutual funds. The real story is found within the pages.

Let’s navigate through the details and complexities, revealing insights that empower investors to make informed decisions in the dynamic world of mutual fund investing.

The Limitations of Past Performance:

As we explore mutual funds more deeply, it is crucial to move beyond star ratings that rely primarily on historical performance. Choosing a mutual fund based solely on its past performance is akin to driving forward while fixating on the rearview mirror. Relying solely on a fund’s past success without considering supporting factors and strategies can result in unforeseen consequences if these factors change or do not pan out well in the future.

Consider a mutual fund that outperformed others during a bull market, indicating economic growth. Investors might deem it a star player, celebrating its achievements. However, what happens when market dynamics shift? A fund excelling in prosperous times might struggle during an economic downturn. This is where the adage “past performance is not indicative of future results” holds true. It’s crucial to assess a fund’s performance in both up and down market conditions to identify more reliable performers.

Here is an example of a bull and bear market comparison of 2 funds, Fund A and Fund B…

This table is illustrative. Past performance is not indicative of future results.
Source: PersonalFN Research 

Fund A excels at generating high returns and typically outperforms Fund B in upward-trending markets. Yet, a closer look shows it tends to lose more value in falling markets.

So which fund will you prefer out of these?

The decision may seem straightforward if you only consider the most recent performance. In this case, you are likely to favour Fund A due to its recent high returns compared to Fund B.

This graph is illustrative. Past performance is not indicative of future results.
Source: PersonalFN Research 

However, Fund A is not as dependable in maintaining consistent performance. The high returns it achieves during bullish phases might be due to taking greater risks compared to Fund B. This tendency to incur significant losses during bearish phases could negatively impact its overall long-term performance.

In fact, Fund B shows better stability and has the potential for long-term success, offering increased value appreciation with relatively lower risk. As I mentioned earlier, when picking mutual funds, it’s essential to consider more than just past performance; there are other important factors at play.

Understanding the dynamic nature of the financial world, it is essential to consider that past performance isn’t the sole factor influencing a fund’s future. While history provides insights, a fund’s strategy, adaptability to economic conditions, interest rates, and global events play crucial roles.

Making wise investment choices requires a forward-looking approach, recognising that investing is about future possibilities. So, is it wise to choose funds based on a rating that is derived majorly from its past performance? Just think about it.

Understanding the Risks:

Risk is a crucial aspect of mutual fund investing, akin to a roller coaster ride with its highs and lows. Unfortunately, many rating agencies prioritise the fund’s past performance over risk. Every investment involves uncertainty, including mutual funds. A five-star rating may promise a smooth ride, but it doesn’t always reveal the underlying risks.

Understanding the fund’s risk elements is like putting on a seatbelt before a safe long drive. Consider a fund heavily invested in a specific sector, like technology. While it may soar during favourable tech stock movements, it could face challenges when the sector falls out of favour, as seen in the 2nd half of 2021 and 2022.

Deeper examination of a fund’s strategy, goals, and risks is crucial in mutual fund investing. Being aware of the risks is as vital as understanding potential rewards. A reliable rating system should assess not only past performance but also understand the details of the risks for a comprehensive evaluation of a fund’s potential.

However, are past returns and risk-reward parameters enough for a comprehensive assessment and star ratings? Or is there more to consider?

Beyond Star Ratings – A Holistic Approach

Most mutual fund ratings heavily rely on historical performance, emphasising quantitative data like returns and risk ratios. However, making investment decisions based solely on high star ratings, derived from past returns and risk-reward numbers, may not guarantee favourable future outcomes.

A 4-star or 5-star rating today does not guarantee it will stay if the fund’s performance drops. Blindly relying on popular star ratings is not foolproof. It is important to understand the rating process and ignore market noise.

How to Approach Mutual Funds?

For successful investing, it is wise to adopt a comprehensive approach considering quantitative and qualitative factors, supported by a diligent research process, when choosing reliable mutual funds. Quantitative factors focus on how the fund performed in the past, while qualitative factors explore why it performed that way. This comprehensive approach helps evaluate the factors behind a fund’s success or failure, providing better guidance on its future potential.

Unfortunately, most star ratings only focus on the quantitative aspect, neglecting the qualitative side.

PersonalFN’s SMART Score Matrix

Source: PersonalFN Research 

To address this, at PersonalFN, we use a S.M.A.R.T. rating process that considers both quantitative and qualitative parameters for a 360-degree evaluation and forming a comprehensive opinion on the fund. I am not saying our process is better than others, but the SMART rating is more comprehensive in nature

Here…

S – stands for Systems & Processes, evaluating the fund house’s philosophy, process, people, and performance.

M – assesses Market Cycle Performance, gauging consistency across bull and bear phases.

A – analyses Asset Management Style’s alignment with the investment mandate.

R – considers various Risk-Reward Ratios, assessing performance relative to the risk and peer comparison.

T – examines past performance Track Records across different periods.

As you can see, while the SMART process does consider returns and performance track records, it is just one of the parameters used for the comprehensive evaluation and selection of the funds. Whereas there are a host of other qualitative parameters that stand as a guiding principle to understand the fundamentals and evaluate the quality of the fund.

Now, let us understand each of these in detail:

S – Systems and Processes

Systems and processes are crucial in a well-organized investment setup, providing insights into the fund house’s philosophy and process. This framework ensures performance isn’t solely dependent on personal judgments, enhancing predictability.

In mutual fund investing, understanding the fund house’s fundamental philosophy is often overlooked. Many rating agencies neglect this qualitative aspect, making it challenging for investors to assess reliable investment systems and processes.

The absence of this qualitative consideration raises concerns about the reliability of some rating systems, leaving investors puzzled and hindering informed decisions. Mutual fund schemes from fund houses with strong investment systems and experienced fund managers are more likely to succeed in the long run.

Considering a fund manager’s consistent track record is crucial for navigating various market conditions. Parameters like a fund’s philosophy, fund house efficiency, and the manager’s experience are often overlooked in typical star ratings but are essential for predicting lasting success.

M – Market Cycle Performance

The market cycle performance is crucial for assessing how a fund fares in different market conditions, be it during positive or challenging phases. It helps investors gauge the fund’s resilience across various market scenarios.

Consider a fund’s track record during bear markets, i.e. times of downturn. Funds performing well in such conditions are seen as low risk-takers, showcasing an ability to navigate and limit downside risk. These funds act as a financial safety net during tough times, protecting investments from substantial erosion of capital.

The real test for equity mutual funds comes in bear markets, revealing which funds excel at handling challenges. It serves as a report card, showcasing a fund’s ability to navigate the ups and downs of the market effectively. Funds that can navigate tough times are better equipped to protect investments when the investment world gets a bit rocky

A – Asset Management Style or Asset Quality

Asset management style is a crucial aspect influencing a mutual fund’s performance. It provides insights into how the fund manager handles the money, indicating concentration risk and trading activity. Understanding a fund’s style, strategy, and investments, including factors like portfolio P/E ratio, portfolio dividend yield, concentration of portfolio holdings, portfolio turnover ratio, and credit quality of portfolio holdings, helps assess its asset management quality.

A fund should stay true to its style and investment mandate. Comparing two different styles of funds with each other may not be fair as they operate differently. When evaluating funds, it is beneficial to reward those sticking to their mandate with good-quality holdings, ensuring a well-balanced and planned investment for the long run. Give preference to funds that stay true to their promises and have a mix of quality investments, providing confidence in where your money is being invested.

R – Risk Reward Ratios

The Risk-Reward ratios help understand the level of risk a fund takes to achieve returns. Evaluating a fund’s reliability and performance involves considering ratios like Sharpe and Sortino, indicating past returns adjusted for risk. Higher Sharpe and Sortino ratios are desirable for better risk-adjusted returns. Standard deviation, measuring volatility, is another crucial ratio, with lower values indicating more stable performance. Jensen’s Alpha and other ratios, such as up/down capture ratio and information ratio, provide additional tools for selecting suitable funds.

Many rating agencies incorporate risk-reward ratios in their process, aiding in understanding a fund’s risk and return profile for informed decision-making.

Our approach emphasises the importance of considering risk thoughtfully, not just mathematically. A comprehensive evaluation of these ratios offers a detailed understanding of a fund’s performance and its ability to navigate market challenges and opportunities.

T – Performance Track Record:

When selecting funds, it is wise to assess their performance over different time frames, ranging from short to long term-6 months, 1 year, 2 years, 3 years, 5 years, and so on.

Using rolling returns offers a thorough evaluation of a fund’s consistent performance and wealth creation over time. Moreover, consistently positive track records during these time frames make funds more appealing.

However, it is essential to note that past performance, while useful, doesn’t guarantee future returns. You as an investor should be aware of changing market conditions and other influencing factors. Considering other factors alongside historical performance is crucial for making well-informed investment decisions.

To Conclude:

Moving beyond star ratings, it is crucial to take a broader view when investing in mutual funds. Star ratings are just a starting point, offering guidance on past performance but not predicting the fund’s future. A comprehensive rating model, considering qualitative aspects alongside performance parameters, reveals fundamentally sound and reliable high-quality funds.

To build a strong mutual fund portfolio, look beyond the star ratings. Explore the fund’s investment strategy, assess risks, understand its objectives, and ensure alignment with your financial goals, risk tolerance, and investment horizon.

In this approach, star ratings are just a small piece of the puzzle. A holistic approach ensures informed decisions, creating a diversified portfolio resilient to changes in the dynamic world of mutual fund investing. If unsure, seek advice from a SEBI-Registered Investment Advisor for personalised guidance based on your financial situation and goals.

Remember, a successful investment journey involves looking beyond star ratings and making well-informed decisions. That covers the key mistake mutual fund investors often make when choosing funds to invest in.

This article first appeared on PersonalFN here