With thousands of mutual funds run by several fund houses, choosing investments could be quite daunting. Maybe that is the reason why mutual fund ratings/rankings are increasingly popular with today’s investors. Before using mutual fund rating/ranking, you need to understand how they are calculated and whether they are useful.
How are mutual fund ratings done?
Rating agencies use qualitative and quantitative parameters to rate funds. Quantitative factors are ratios such as alpha, Sharpe ratio, Treynor ratio, etc. Other factors such as liquidity, portfolio concentration, and credit quality are considered by analysts before providing ratings to mutual funds. Qualitative factors will include fund manager track record, fund house history and investment objectives.
The most common way of rating mutual funds is by assigning stars to the funds. Five stars represent the highest rating, while one star represents the lowest. The rating typically measures the fund’s historical risk-adjusted performance over different time frames. The rating will be relative to that of the funds in the same category. Usually, the top 10% of funds are given a 5-star rating, while the bottom 10% will have a 1-star rating.
How are mutual funds ranked?
Based on the risks associated with the mutual funds, fund performance and the cost of the fund, agencies rank mutual funds. For instance, Morningstar ranks mutual funds on a scale of one to five stars. These rankings are based on how the fund has done compared to funds in the same category. The agency provides separate ratings for three-, five- and 10-year periods, which is combined into an overall rating.
If you consider agencies such as CRISIL, they use a combination of net asset value (NAV), and portfolio-based attributes for evaluation. CRISIL considers key parameters such as risk-adjusted returns, asset concentration, liquidity and asset quality for assigning mutual fund rankings. The ranks are assigned on a scale of 1 to 5, with Rank 1 indicating ‘very good performance’.
Why are ratings/rankings useful?
Ratings and rankings help investors compare funds within a category. Any investor can see that a 5-star rated fund is superior to a 4-star fund. They needn’t be well versed with the workings of a mutual fund to find a highly rated fund.
Another important point is that these ratings and rankings are calculated based on relevant factors and are not random. Since considerable research is done for ratings/rankings, they help investors choose funds with confidence. Also, the history of the fund is considered before it is rated/ranked. The time frames chosen to calculate risk-adjusted returns are 3-year, 5 year and 10-year trailing returns. These period-based risk adjusted returns are combined to provide rating/ranking of the fund. So, the ranking/rating is a reflection of the fund’s functioning in the long term.
Should you use fund rankings/ratings?
Mutual funds are market-linked investments and past performance doesn’t guarantee high returns in the future. Mutual funds get rerated from time to time based on their performance. So, a 5-star fund could get easily downgraded over the coming year because of its poor performance.
Another point to note is that rating changes happen after good/poor performance of the fund. For instance, a 4-star fund gets promoted to a 5-star fund after it has done well in the past year. So, those who are buying only 5-star funds will not have an edge against those who buy 3-star and 4-star funds in the long run.
The most important flaw with rankings/ratings is that they are overly simplistic in determining which is the good and bad funds. All good funds may be suitable for all the investors’ portfolios. Investors could be young and old, rich or poor, salaried or entrepreneurs etc. So, the risk profile of every investor is different. So, choosing 5-star funds will not be right for every other investor.Â
What should you do?
As opposed to selecting funds based on their rankings/ratings, you could use them to eliminate bad funds. Past data tells us that funds with low ratings tend to stay low for long periods. So, when you have shortlisted mutual funds for investments, use their rankings/ratings to eliminate those funds that come with a low ranking/rating. This will essentially help you avoid funds with an unreliable or unsatisfactory history and overall potential.
You could use the changes in ratings to monitor your funds. Changes in ratings could be a sign for you to evaluate the fund in your portfolio.
Understand that mutual fund ratings are not completely free of risk and bias. They must not be used as the only criterion for you to invest in a mutual fund. You should look at other factors such as investment philosophy and track record of fund house. Make sure that you choose your investments based on your own unique requirements. Need help? Contact your consultant at wealthzi.com.
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