Why You Should Stop Looking At Mutual Fund Star Ratings Now (2024)

Although he may not get his fortune right, he is quite happy when he knows the precautions he needs to take for the day; with his job, with his family, his friends, and enemies too.

Many of you might have a somewhat similar inclination for Astrology.

The word 'Astrology’ is derived from two Greek words, ‘Astra’ which means ‘a star’, and ‘Logos’, which means a ‘logic or reason’. It signifies the movement of stars and planets that can have influence on your life.

Do Stars Talk?

Of course, tracking them helps us predict the future or fortune of an individual or entity.

But do they really stand true in case of mutual funds?

Can they really predict the fortune for mutual fund investors? Or would they just be a redundant symbol, going forward?

To meet the SEBI’s categorization and rationalization norms, mutual fund schemes are being re-categorized under different investment style, and many are being merged with other funds. In such a scenario, basing your investment decision on the past performance of the fund, which will now on be following different investment style altogether, is completely meaningless for you, the investor.

So would you rely on Star Ratings derived looking predominantly at such past performance numbers?

Say, for instance, you have invested in mutual funds for its 5-Star rating.

You were probably happy that you invested in a 5-star rated fund. This may even help you sleep peacefully at night.

Did you revisit the rating again? Has the fund, you had invested in, lost few of its stars?

What would you do in case it did?

You might simply stick with the fund you invested in, or else try to identify the next fund with a 5-star tag and switch to it.

Did you ever wonder, why your fund lost its stars? Was it sheer bad luck or did it never had potential to continue retaining the spot?

If you find that, except performance, all other factors of the fund still remains unchanged, i.e. its fund manager, its investment style, concentration, etc.; then, probably you might have got your timing wrong.

I will tell you why.

Even Best Mutual Funds Can Have Phases of Good and Bad Performance Cycle

Every mutual fund follows a particular investment style, based on its objective and pre-defined strategy. Each investment style has its own cycle. A top performing fund that made the best in a bull phase of its investment style may end up among the laggards, if the style enters the unfavourable phase.

You probably invested in the fund after it had already made the most of the cycle and generated returns for its investors, which helped it gain maximum stars. By the time you identified the fund, the style was about to enter its next phase, which resulted in a slowdown in its performance, thus losing the stars for the fund. So did your investments.

Don’t Fall For Passive Star Ratings to Predict Future Performers

Most mutual fund research entities follow the passive rating methodology, where they give very high weightage to quantitative factors like past performance and risk adjusted returns over a period of say 3 to 5 years and compare it with their peers to arrive at the best return generators in the lot.

In my understanding, these stars, derived from passive numbers at best, reflect how the fund has performed vis-à-vis its category peers over the last few years. Moreover, with the change in performance cycle, the ratings can change dynamically.

While looking at the past performance data of mutual funds is rational, what about the future growth potential and consistency of the fund?

What about the portfolio quality and investment style?

What about the portfolio maturity analysis, credit quality, and expenses that is significant while picking debt funds?

Where is the much-needed analysis about the fund managers skills and experience? And the investment systems and processes followed at the fund house, etc.?

These qualitative factors are more important than the historical performance, to judge the future growth potential and long-term consistency of the fund. Ignoring them completely, while arriving at the stars you probably use to select the funds for your portfolio, may never get you the real stars of tomorrow.

The interesting part is with the new classification and re-categorization of mutual fund schemes, these stars would be completely redundant and misleading if they are derived only on the basis of historical performance numbers.

What Has Changed For Mutual Fund Investors?

The age-old practice of using fancy names for mutual funds is almost redundant.

While some names were glorified, some were purely misleading. In terms of investment style, some schemes practiced completely different from their name or objective mandate.

To stop this practice and provide proper demarcation, in October 2017, the SEBI came up with its circular on “Categorization and Rationalization of Mutual Fund Schemes”.

In the circular, the regulator defined 36 categories for mutual funds to make investing simpler for mutual fund investors.

In the circular, the regulatory body directed all fund houses to relook at their scheme categorization and realign their schemes and underlying portfolios to these new categories.

Following this, mutual funds have started announcing scheme rationalisation and categorisation as per the SEBI circular.

While it thought that due to rationalisation norms, several duplicate and fancy schemes would be merged with others and wiped out; the mutual fund houses have managed to retain most of their schemes, by tweaking their objective and style to match the new categories defined by SEBI.

Some Strange Re-Categorization…

Here is the list of schemes that have decided to switch their investment style to a different category, and are about to begin a new journey.

As you can see, many equity as well as debt schemes are expected to change their investment style and move to a completely new category. Their previous performance track record would not hold true for their newly adopted style. Moreover, there are some strange re-categorization that are done to keep schemes alive.

Some fund houses, like SBI, have gone a step ahead to adopt a new theme altogether. Creating a new ESG (Environment, Social and Governance) and changing the style of its large-cap oriented fund ‘SBI Magnum Equity Fund’, to a thematic fund, is something that was least expected.

Similarly, SBI Global Fund, which was a mid-cap fund focused on picking quality mid cap stocks, will focus on MNC stocks now onwards.

It seems, the fund house found it more convenient in changing the style and category instead of its name. You as an investor would definitely not stick to the funds that do not meet your objective.

In my opinion, mutual fund houses could have been more responsible in ensuring that investors do not face much hassle and their objective of investing in the scheme does not show much deviation. However, sticking to the schemes without re-evaluating the suitability of the new style to your investment goals can be risky for you.

It’s Time To Look Beyond Stars And Performance…

So like we’ve established, with these changes, picking schemes based on ratings derived from their historical performance can be misleading.

These funds will need at least another 2-3 years to develop a credible track record which can be used to rate them.

Until then, they can be decided on their features, portfolio characteristics, and management quality. It is the time to give more weightage to fund and fund house quality and consistency over historical returns.

At PersonalFN, while analyzing funds, we give weightage to both quantitative as well as qualitative parameters.

Here is the list of checks we do under our Quantitative and Qualitative Parameters…

→ Quantitative Parameters

Testing on Performance Parameters and Risk Analysis

- This is to analyse, if the fund has shown consistency in performance across various points and provides decent risk adjusted returns. Under this, each fund is tested and scored on various quantitative parameters like 1 Year Rolling Returns, 3 Year Rolling CAGR, 5 Year Y-o-Y Rolling Average Returns, and also on risk reward ratios like Sharpe Ratio, Sortino Ratio and Standard Deviation.

Testing on Consistency across market cycles

- This parameter is to ensure that the fund has the ability to perform consistently across market cycles. Here we compare schemes performance vis-à-vis their benchmark index across bullish and bearish market phases and accordingly score on its performance consistency and number of cycles survived. Underperformers will score low.

→ Qualitative Parameters

Testing Portfolio Quality

- We believe, scheme should not hold highly concentrated portfolio. Therefore, we score schemes on portfolio characteristics like concentration of top 5 and top 10 holdings.

- To ensure that balanced funds do not hold low or unrated debt instruments, we also consider credit quality rating score of debt portion of the portfolio held by balanced funds

- Engaging in high churning can result in trading and high turnover cost. Therefore, in our process, we also score schemes on portfolio characteristics like portfolio turnover ratio and expenses, and penalise funds involved in high churning.

Testing on Quality of Fund Management

Apart from schemes, we also test the fund manager and consistency of the fund house. Here we check if…

- The fund manager is over loaded with large no of schemes.We score on parameters like fund manager to scheme ratio, i.e. no of schemes managed by a single fund manager. We believe a single fund manager should not manage more than 5 funds. If the number of funds managed by a single fund manager exceeds 5, we consider him overburdened.

- The fund manager has decent work experience. We score on the average work experience of all the fund managers in the fund house, to ensure the investors’ money is in experienced hands.

- The fund house is not active in only raising AUM. For many years, in our process, we consider the duplicate schemes launched by the fund house and accordingly penalise the fund house if they have many duplicate schemes. Multiple schemes with same objective means low score for the fund house.

- Efficiency of the fund house in managing your money : We calculate the efficiency of the fund house by checking and scoring on the percentage of AUM performance, which helps us understand what proportion of the total AUM of the fund house is performing and what proportion is underperforming. It helps judge the efficiency of the fund house in managing the garnered corpus.

In our process, adequate weightage is given to each of the parameters mentioned above and the funds are scored on each of them. Based on the composite score, PersonalFN arrives at views on each fund recommend under various mutual fund research services.

You see, the process we follow at PersonalFN is much more comprehensive in nature. We do not rely only upon quantitative parameters that is passive in nature. The qualitative parameters we use, helps us project the long-term consistency and stability that can be expected from quality portfolio and fund management.

While we may not aim for top performers, what we look for is quality funds that can be consistent performers in the long run.

So the next time you look at Star ratings that are derived merely on the basis of performance numbers, it will be best to consider this criteria as a measure of the funds historical performance and not a measure of top-rated future performance.

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1. Money Simplified Services Private Limited;
2. PersonalFN Insurance Services India Private Limited;
3. Equitymaster Agora Research Private Limited;
4. Common Sense Living Private Limited;
5. Quantum Advisors Private Limited;
6. Quantum Asset Management Company Private Limited;
7. HelpYourNGO Private Limited;
8. HelpYourNGO Foundation;
9. Natural Streets for Performing Arts Foundation;
10. Primary Real Estate Advisors Private Limited;
11. Rahul Goel;
12. I V Subramaniam.

Disclosure with regard to ownership and material conflicts of interest

1. Neither QIS, it’s Associates, Research Analyst or his/her relative have any financial interest in the subject Company , except QIS receives fees for providing research to Quantum Equity Fund of Fund (QEFoF) which is Fund of Fund scheme managed by QMF.
2. Neither QIS, it's Associates, Research Analyst or his/her relative have actual/beneficial ownership of one per cent or more securities of the subject Company, at the end of the month immediately preceding the date of publication of the research report.
3. Neither QIS, it's Associates, Research Analyst or his/her relative has any other material conflict of interest at the time of publication of the research report except that QIS (PersonalFN) is, as per SEBI (Mutual Funds) Regulations 1996, an associate / group Company of Quantum Asset Management Company Private Limited and Trustees and Sponsor of Quantum Mutual Fund (QMF) and to that extent there may be conflict of interest while recommending any schemes of QMF. However any such recommendation or reference made is based on the standard evaluation and selection process, which applies uniformly for all Mutual Fund Schemes. The payment of commission (upfront /annualized & trail), if any, for any Schemes by QMF to QIS (PersonalFN) is also at arm's length and as per prevailing market practices

Disclosure with regard to receipt of Compensation

1. Neither QIS nor it's Associates have any compensation from the subject Company in the past twelve months.
2. Neither QIS nor it's Associates have managed or co-managed public offering of securities for the subject Company in the past twelve months.
3. Neither QIS nor it's Associates have received any compensation for investment banking or merchant banking or brokerage services from the subject Company in the past twelve months.
4. Neither QIS nor it’s Associates have received any compensation for products or services other than investment banking or merchant banking or brokerage services from the subject company in the past twelve months except from Axis Bank Limited under a service agreement.
5. Neither QIS nor it's Associates have received any compensation or other benefits from the subject Company or third party in connection with the research report

General disclosure

1. The Research Analyst has not served as an officer, director or employee of the subject Company.
2. QIS or the Research Analyst has not been engaged in market making activity for the subject Company.

Subject Company means Mutual Fund Schemes

Quantum Information Services Private Limited CIN: U65990MH1989PTC054667 Regd. Office: 103, Regent Chambers, 1st Floor, Nariman Point, Mumbai - 400 021 Corp. Office: 103, Regent Chambers, 1st Floor, Nariman Point, Mumbai - 400 021. Email: info@personalfn.com Website: www.personalfn.com Tel.: 022 61361200 Fax.: 022 61361222

SEBI-registered Investment Adviser. Registration No. INA000000680, SEBI (Investment Advisers) Regulation, 2013

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