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MFs: Why 5-star rating won't work always

By Jayant Pai
September 27, 2010 11:56 IST
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For some years, various financial publications and television channels have been extolling the virtues of participating in stock markets via mutual funds (MFs).

Wide diversification, low cost and risk reduction are the advantages. But, once a prospect is sold in the name of MFs, there is the problem of choice. There are funds of all sizes with different risk-return characteristics.

One of my friends has a neat filter to sift this maze. He chooses from those rated 'five-star' by reputed agencies. While this seems amateurish, it is a bit disconcerting that MF advisors also adopt the tactic.

Intuitively, this approach seems appealing. After all, why re-invent the wheel when somebody else has already done the hard work for you and clients also agree?

While it is true that 'five-star' rated funds are usually good performers, it may not be appropriate to get fixated on these for the following reasons:

Differences in rating methodology: For instance, while Value Research (VR) and Morningstar (MS), two of the most reputed agencies, rate funds using quantitative risk-return based metrics, and assign a 5-star rating to funds appearing in the top 10 per cent, the former uses a simple average of the three-year and five-year ratings, while the latter uses a weighted average of the 3, 5 and 10-year ratings, with more weight assigned to the longer-term rating.

There are also subtle differences in the measurement of riskiness. Hence, popular and well managed ones such as Fidelity Equity Fund and Birla Frontline Equity are rated 4-star by VR and 5-star by MS. An investor insisting on 5-star funds may tend to overlook some good ones only because they do not make the cut in an agency's assessment.

Musical Chairs: Investors are advised to hold on to MFs for long periods of time. However, funds constantly enter and exit the 5-star 'winners circle'.

For instance, Sahara Mid Cap and Principal Large Cap enjoyed a VR 5-star rating in November 2009 but are now rated 4-star. Shuttling in and out of funds based on this may result in exit loads and taxes.

Rarely is a fund able to hold on to the 5-star rating for a continuous period of three years or more. Any rating usually holds only for a certain point in time and only in relation to its peer universe. It is not an iron guarantee that the fund will remain a stellar outperformer in future. It only helps in making an educated guess on future performance.

Suitability: The amount of allocation to equity MFs, and the choice of funds therein, is dictated by your personal goals, willingness and ability to take risk. It may so happen that a lower rated fund may be more suitable to your individual case as compared to a higher rated one.

For instance, UTI Dividend Yield Fund may not suit an aggressive investor as much as Reliance Growth Fund will, despite the former's VR 5-star rating. Besides, VR does not rate certain sector funds like Franklin Infotech, Reliance Pharma, ICICI Prudential FMCG and Reliance Diversified Power Fund, despite these being in existence for over five years and performing well.

This is because VR requires that a category have a minimum of 10 funds to be rated. These funds may be suitable for certain investors and advisors should not steer clear of these merely because they are unrated.

Winners curse: It is very easy for advisors to sell 5-star rated funds, as clients are already pre-sold to the idea of buying these. However, in case the fund attracts too much money, it may suffer from the 'winner's curse' syndrome by losing its nimbleness and underperforming, thereby causing disappointment all around. This is a perceptible hazard in the case of mid-cap funds.

Advisors should recommend a fund after assessing certain quantitative and qualitative parameters, such as returns over different market cycles, ability to contain downside risk, adherence to its stated mandate, performance under different fund managers, expense ratio, turnover ratio, etc. It does involve some work but this differentiates good advisors from the rest.

When it comes to choosing a fund, a 5-star rating is neither a necessary nor sufficient condition. What matters is whether it is a good fit in your portfolio or not. By the way, the two agencies mentioned above state the same thing in their disclaimers.

The writer is a certified financial planner.

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Jayant Pai
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