Should you rely on mutual fund ratings?

In India, many mutual fund schemes can confuse the ordinary investor. Many of these schemes are similar in flavour, worsening the confusion even further. Generally, investors sift through the performance of various mutual fund schemes for a particular time frame. But, this fixation on past performance may not be their best bet. Investors need a better parameter to help them decide which mutual funds are suitable for them.

Mutual fund ratings are here for the investor’s rescue. Many investors consider these ratings during decision-making. Various rating agencies issue these fund ratings.

What is a mutual fund rating?

Expert investors evaluate investments from two lenses – returns and ratings. Mutual fund ratings are generated based on the fund’s past performance, the fund manager’s skill, performance consistency, and cost-adjusted returns.

Many rating agencies provide their results on mutual fund schemes. Popular agencies are Value Research and ICRA, Morningstar, CRISIL, and CARE. The calculation of ratings is based on qualitative as well as quantitative parameters.

The quantitative factors focus on the overall mutual fund performance. It is measured by the Treynor ratio, alpha, and the Sharpe ratio. The other factors that guide agencies about mutual fund schemes are volatility and liquidity.

In addition, quantitative factors include Portfolio Concentration and the credit quality for debt funds.

When it comes to the qualitative factors, agencies look at the fund manager’s track record, the mutual fund’s reputation, and the investment process.

A majority of mutual fund investors believe that mutual fund ratings are essential.

Why are mutual funds ratings essential?

A majority of mutual fund investors consider mutual fund ratings as vital. Here are three reasons that indicate its importance:

  1. Elimination

The calculation of mutual fund ratings is based on quantitative and qualitative factors. As a result, it helps in eliminating the bad apples from the choice bucket.

With the help of mutual fund ratings, investors can learn about funds that have an unsatisfactory or unreliable history yet overall potential. Moreover, they can help investors avoid high-risk investments.

  1. Monitoring

An investor can benefit from changes in ratings, especially if you don’t have the time and effort to track the portfolios. Some newbie investors who do not possess the required skills can benefit from mutual fund ratings.

A change in mutual fund ratings can be caused by meaningful qualitative and quantitative changes in the fund characteristics. That can indicate something good or bad.

  1. Simplification

Investment decision-making becomes more effortless and simplified with mutual fund ratings. The single metric lets investors choose the right fund for their portfolios.

If you come across a 5-star rated fund, you know it is better than a 4-star rated fund. This rating helps investors make quick decisions using simplified market data.

How to use mutual fund ratings?

Mutual fund ratings are generic. You shouldn’t invest in top-rated funds only. You do not buy only the best medicines when you visit a pharmacy. You ask for the drug as per your requirement.

When selecting mutual funds, you must choose categories that suit your financial goals. Within that category of mutual funds, you can see top-rated mutual funds.

You must prioritize the selection of a suitable mutual fund category over the search for a mutual fund rating. You will not enjoy any benefit from the investment if you focus on the mutual fund rating in an inappropriate category.

What do better mutual fund ratings mean?

Mutual fund ratings can’t guarantee better returns. But, in the long run, the performance of mutual funds with a higher rating performs better than those with a lower rating. Nevertheless, exceptions always exist. Sometimes, mutual fund schemes with a lower rating can outperform the higher-rated ones. It is very unlikely that a 5-star rated mutual fund will go out of rating in comparison to a 1-2 star rated mutual fund.

Limitations of mutual fund ratings

Mutual fund ratings act as a starting point for further research. They are not buying or selling recommendations. There is also a major limitation attached to it. These ratings are a backward-looking assessment mechanism. They do not indicate the rating agency’s opinion on the potential of a fund.

According to mutual fund rating agencies, the ratings look backwards. Since past performance cannot predict the future, investors should regard the ratings only as a filtering process to select the mutual fund.

Summary

Mutual fund ratings act as a starting point for filtering funds. Investors must not rely on it completely when selecting fund schemes. This is because the ratings are dynamic, and you need to give importance to other factors that can impact returns as well.