Are Mutual Fund Star Ratings any Useful?

Thousands of people rely on mutual fund star ratings for picking good or best mutual funds to invest in. It’s a popular metric amongst investors and advisors alike.

These stars (ratings) are provided by agencies like Morningstar, Value Research, Money Control, CRISIL, etc. Most of them rate funds on several parameters and come up with a star rating – which ranges from 1-star to 5-stars. Top funds get 5-stars and ones at the bottom get 1-star.

It’s a simple method of comparison for investors and advisors. Naturally for fund houses, it is also a free method of advertisement for their well-rated products. 😉

Most people believe that a 5-star rated fund will perform better than all others. But truth is that… this is not necessary.

So…

Are Mutual Fund Star Ratings really useful?

Before we move on to discuss this important question, let’s understand why these ratings are so popular first.

The number of funds available is overwhelming and unnecessarily large and most people don’t know how to pick the right mutual fund schemes. So they take the easy way out and end up relying on star ratings.

In words of the founder of Morningstar, the star rating system ‘is a way to whittle down a big universe into something more manageable.’

I agree here.

Mutual Fund (star) ratings are designed to help investors quickly identify funds to consider for their investments. For starters, they give investors a quick-and-dirty opinion on the chosen fund within minutes. And this is perfect for our era of time-poverty.

But the problem arises when investors rely solely on these ratings to pick funds.

They treat these stars as a guide to future performance and high star rating to be a definite buy signal.

This is not the right approach. It is plain stupid.

Mutual fund ratings by themselves do not guarantee high returns in the future.

It is not at all necessary that a 4- or 5-star rated fund will always perform better than a 3-star one. But it is generally expected that over a period of time, better rated mutual funds do perform better than lower rated ones. But there are numerous instances where lower rated funds have outperformed higher rated ones.

In this post, I don’t intend to talk negatively about rating agencies. There is nothing wrong with the concept of star ratings. These are based on actual data and solid maths.

The idea instead is to remind investors that they need to look beyond star ratings. Many investors rely blindly on star ratings and have questions like:

• Should I choose only 5 star rated mutual funds?
• Should I choose only mutual funds that are either 4 or 5 star rated?
• Should I switch out of my mutual fund investments every time my fund’s rating is downgraded?

These investors need to wake up and understand that the star ratings are not enough.

But investors alone should not be blamed. Many financial advisors love star rating systems too.

They take this easy route and use star ratings to justify their advice. 🙂 I have seen this being done by many advisors! Even many of you would have experienced it. It’s a cover-your-@$$ type of service… An advisor can say, ‘I’m going to put you in this fund, it’s a 5-star fund,’ …and if something goes wrong the advisor can shunt blame to the rating agency.

🙂

But keeping aside advisors and rating agencies for a while now…

Why you should not blindly depend on ‘Mutual Fund Ratings’?

Ratings do a decent job of accurately analyzing a fund based on its past performance (and few other criteria). But the downside is that this isn’t a good guide to future performance.

You cannot use these ratings to correctly predict future performance. And that is what most people forget.

Remember the standard disclaimer that has become too common for its own good?

“Past performance is no guarantee of future results.”

It is not just a disclaimer. It’s a reality!

Most fund rating agencies do suggest that their star ratings are backwards-looking assessments. And since past performance is no guarantee of good future performance, one should consider the limitations of these ratings when making investment decisions based on them.

At best, these ratings should be considered as a sort of filtering mechanism when selecting mutual fund(s) to invest in. Both for lumpsum and SIP investments.

If necessary, then investors should only use this rating data as a starting point, combine it with other important factors (consistency, suitability, fund objective, portfolio, expenses, fund manager’s track record and experience, investment process followed, the integrity of the fund house, etc.) for shortlisting funds.

My view is that these ratings may not be even a good starting point for research. I prefer taking the data and analyzing it myself.

And think of it, it would be really great if picking funds were as simple as looking at how many stars it has earned. If rating agencies believed in their ratings, they would be running big portfolio funds which would be investing in these high-rated funds. 😉 That is something to ponder about.

And it’s not just me who is being sceptical here. Even Morningstar’s CEO voices similar thoughts here:

• We recognize and have often acknowledged the limitations of a measure like the star rating that’s based on past performance, but we also believe it can usefully tilt the odds in investors’ favor, when combined with other research and tools.
• We’ve long described the star rating as a worthwhile starting point for research that can help investors make good decisions when combined with other research and tools.

I say this again – mutual fund ratings as a concept is fine. But as an investor, you need to focus on more important things.

Instead of looking to invest in all the top rated mutual funds, you first need to ensure whether you got the category of the mutual funds right or not. And that is after you have decided which financial goals you are investing for.

Choosing the highest rated fund in the wrong category can kill your investments and you risk not achieving your financial goals. Being in the ‘Right’ fund in the right category is much better than being in the ‘best’ fund of the wrong category.

The ‘best’ mutual funds suited for your real goal-based investing needs may not necessarily be 5-star rated. They may not be category toppers too. Also, a high ranking for a particular fund does not mean that it will be necessarily suitable for each and every investor.

Another issue is that different strategies (fund’s investment strategy) or styles go out of favor and then come back after a few years. So if you exit a fund that has dropped in rating due to their particular reasons, chances are that you will miss out when the strategy returns with all guns blazing.

This is something that most people don’t realize when going via ‘I-only-bother-about-fund-rating’ route.

Is it a Mirage?

Recently, a Wall Street Journal (WSJ) article titled The Morningstar Mirage created a lot of drama in the investment fraternity. And the subtitle of the article got straight to the point:

Investors everywhere think a 5-star rating from Morningstar means a mutual fund will be a top performer – it doesn’t. 😉

In the article, WSJ concluded that the top-rated funds attracted a majority of investors’ money (in the US) but most didn’t continue performing at that level. Unsurprisingly, the rating agency in question hit back (link) with its counter-views protecting itself; and in essence, claiming that their ratings were not supposed to be predictive and they should be a starting point for investors selecting funds. Their CEO also pitched in with his views (link).

If you go through all the articles related to this particular episode, you will understand that the rating companies also know about the shortcomings of star ratings but they have a business to run. 😉

Let’s talk about the possibility of a conflict of interest here.

I am sure most mutual fund rating entities are professionally run. And since most information is in the public domain, chances of wrongdoing seem limited.

But who knows… 😉 😉

A fund that is rated well (lots of stars) will attract more investments if fund houses pitch it strategically to advisors and investors. Its easily possible that investors would continue to pour fresh money into top-rated funds even if their performance declines – just because the rating is still high.

So whether they agree or not, the fact is that the rating companies are a big beneficiary of their own ratings. Think about it. I know a few things. Others might know as well. But I am not saying anything more here… 😉 If you know what I am pointing to, you will understand. Else, ignorance is bliss.

And with a sustained rally in Indian equities for last many years, equity is no doubt turning out to be an attractive asset class. At such times, its all the more necessary that the role of mutual fund rating agencies is critically and subjectively assessed.

Maybe, the Fault is not in ‘Stars’ but in Us

Here I quote from an article by Barry Ritholtz that has some apt words:

Retail and professional investor alike seem to ignore the fact that every single document ever generated by any investment-related firm has a warning on it to the effect that “Past performance is not an indicator of future returns.” Every chart ever drawn, each investing idea back-tested and every single historical comparison is testament to how little mind humans pay to that disclaimer.

To borrow from and paraphrase the Bard, the fault lies not in the stars, but in ourselves.

Thus, it should come as no surprise that misunderstanding what fund ratings mean is a very typical error made by, well, just about everyone. It isn’t a forecast of future returns, nor could it be.

If it could successfully do that, [Mutual Fund Rating companies] would have long ago set up a hedge fund to profit from its newly discovered abilities to identify winning investments.

Sounds logical. Isn’t it?

Bottom Line

I reiterate that mutual fund ratings are fine as a concept and provide useful insight into a fund, how it has performed in the past and how it invests. But they are not meant to be used in isolation or as a predictive measure.

When it comes to things like ratings, you cannot build a perfect system. Never. But it’s your hard earned money. You should atleast know the limitations of factors on which you are basing your investment decisions.

The best way to invest in mutual funds in India is not by just looking at the mutual fund star ratings. Ideally, investors need to use data, do some homework and estimate how a fund might perform in future. And that is very important. The rating system alone does not have complete information for making such a subjective judgment.

So should you ignore mutual fund star ratings altogether? Or are mutual fund ratings useful? Or are mutual fund ratings of no use? And will 5 star rated funds perform better than all others? Are star ratings the best way to choose a mutual fund?

I have already shared my thoughts. It’s best if you decide about the final answers to these questions yourself.