What and Why of Mutual Fund Ratings

Star ratings are, at best, a lagging indicator. It can measure what has happened, and that might be very different from what will happen after you invest.

AKA Mutual Fund Rankings do not make Sense! Or Do They?
You will find lot of media (print, TV, blogosphere, sites) screaming their heads off about 5 star funds. Friends swearing about some sites about 5 star funds. We will try and dissect the methodology of this, and then the disadvantages.
1.The major sites (Valueresearchonline, Morningstar, Moneycontrol) first categorise different funds in different categories, according to their own whims and fancies (if you will check, they will tell you they have definite criteria but all those criteria are based on relatively short-term periods of recent past, eg. 1 year or 3 year). Few years back, VRO had a group of Diversified Equity, which later got divided into Large, Large-midcap, Multicap, Mid-Small cap. In future, it can happen with the higher number of funds, that there will be a Large-Medium-Mid and a Medium-Mid group too (who knows!).
2.According to their current portfolio, different funds are kept in different groups at different times. Eg, a flexi-cap fund like HDFC Equity will be placed in Large-mid cap fund group at one time, while at other times it will be put in multi-cap group (which is actually its group). So, the place of individual funds can change over time. Which means, if you categorise HDFC Equity as a 5 star fund in the large-mid cap fund group and later on, its group changes to multi-cap, then the rating of 5 star of large-mid cap is just junk for this particular fund. (For clarity sake, HDFC Equity can invest in any company, will prefer to get mid and large companies, and since its benchmark is CNX 500 (major 500 companies, so it is best characterised as a multi-cap).
3.The method of Rating. A Risk adjusted Return is followed which includes a lot of maths, usage of exotic terminology like 'downside risk', 'utility function theory','risk aversion', etc. Then they compare monthly/weekly returns with a risk-free return (savings bank account rate or short term FD), and assign downside risk and excess returns, do some more jugglery in terms of percentages allocated to various parameters. Then all the funds of a category are separated into different star groups, the top 10% are awarded 5star rating, next 22.5% 4 star (so the top third are 4/5 star).
4.All these ratings are purely quantitative without any subjective component. If the main catalyst of all fund selection – eg the fund manager, leaves, there will be no change in the rating. Even, the complete change of the entire management team like Fidelity leaving lock-stock-and-barrel does not change the rating of their funds which have been taken over by L&T with a new team. Amazing, if you really look at it.
5.Then these ratings are disseminated to people in various forms and adverts. And people flock to the 4 and 5 star funds.
What are the problems in this way? Is it not better to use 4/5 star funds than to use the lower performing funds (the 1 and 2 star funds)?. Yes, selecting funds on basis of stars can be a good start, since most of the long term decent funds are 3 or 4 or 5 funds. But the problems are:
1.The ratings are calculated every week / month (as per category). So, it is possible for ratings of individual funds to change every week/month. So, a person who invested in 5 star fund on Friday may end up getting units allocated in a 4 star on Monday. How bad will that be for the person, and what will he do now with that pathetic looking 4 star fund (sarcasm!).
2.In star rating system, there are no subjective criteria, which makes comparison of the performance of the same fund under different managers / management teams uncomparable.
3.Biggest problem is a 5 star fund may not remain 5 star 2-3-5-10 years down the line. Then what are you going to do and how will you cope up with that. Past performance is not an indicator of future returns, which just means ranking based on past returns cannot tell you if the 5 star fund will remain 5 star 10 years down the line OR the 2/3 star fund will become one. So, all calculations of alpha, beta, standard deviation, volatility, etc BASED on past 1 year (this is most common time frame for these values) cannot tell you the future performance.
4.Comparison of a different style of fund like Value funds (Eg are Templeton India Growth / Templeton India Equity Income and ICICI Discovery) with Growth funds does not work since they are not comparable at all, even if their benchmarks and portfolio capitalizations are similar.
5.Then, if the top 10% of a group are 5 star out of say 20 (which means top 2 will be 5 star). Now let us say, there are 200 funds, then the top 20 funds will be 5 star. So, even though the relative ranking of a fund has dropped from say 2 to 20, it will retain its 5 star ranking - it just needs a constant increase in the number of funds and relative good performance.
So how to proceed?
1.Look behind the Quantitative performances of funds. You can start with the Qualitative Analyses provided by Morningstar for a start. Understand the Fund Company behind the fund. Have they been stable in retaining their management teams? Are they able to generate profits for themselves? If they are not, then it will be difficult for them to retain their teams for longer periods of time or sustain themselves, both of which can prove to be harmful for you.
2.Is the fund manager(s) been with this fund for the last 3-5 years (over which the ratings have been generated and which has attracted you to it)?
3.Is the style of fund consistent over these time periods? And can you stomach that style? Value funds can have long periods of relative underperformance followed by great outperformance as compared to growth funds. Similarly, large cap funds will have lesser volatility than say multicap or mid-small cap funds.
If after selecting funds across these parameters, the fund ratings drop, then you just need to check whether the fund team is still consistent in their approach and their underperformance is because of market cycle. In that case, it will be more beneficial to accumulate more units of the same fund which will help you when the fund regains or upgrades its ratings.
Remember, you make most of your money in Bear Markets, the only problem is you do not know at that time.

Types of Mutual Funds

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