The craze for five-star rated mutual fund schemes is growing rapidly among investors. Many believe that choosing only five-star rated schemes will ensure outperformance of their portfolio. But, there is more to this than meets the eye.
Fact # 1 - Ratings are not permanent - Don’t be misled by the belief that five-star ratings are permanent. Ratings can change within no matter of time if schemes fail to hold on to their exemplary performance. This means that a five-star rating can easily be downgraded to three-star or four-star in an event of declining performance and thus, relying just on this parameter is counterproductive.
Fact # 2 - Category-specific ratings - Ratings are assigned as per the category of the mutual fund scheme. For example, there will be a separate set of ratings for equity-diversified schemes and another set for tax-savings schemes and so forth. A scheme is rated five-star among its category even it that category as a whole is not putting a good show. For example, an infrastructure based (sectoral specific) scheme might be assigned five-star even if its performance is lagging behind an equivalent rated equity-diversified scheme. So, it's equally important to know what category you are investing in rather than rushing to pick up just five-star rated funds.
Fact # 3 - Past performance - Five-star rated status is highly dependent on a scheme’s past performance. As Mutual fund disclaimer points out “Past performance is not indicative of future returns”, therefore, it is not wise to invest mainly on the rating criteria. Also, five-star rated funds have less scope to maintain their rankings compared to three or four-star rated funds, which have the scope to improve and rise.
Look for methodology
Not all rating agencies assign the same rating to a scheme due to the difference of methodology adopted to rate it. Hence, it is wise to look for the rating parameters used by rating agencies to circle a scheme. In general, consistency of returns and degree of risk should be compared to filter the relevant schemes.
Is rating useful at all?
Given the several hidden factors associated with rated funds, it is essential to understand if an investor should pay heed to rating statuses at all. The answer is not explicitly ‘No’ as it will not be fair to throw this parameter out while evaluating schemes.
Ratings do matter in decision making but not entirely. It is recommended to choose between three to five-star rated schemes while keeping an eye on important factors like expense ratio, fund-size, category etc. Also, it is important to analyze a scheme’s performance over a period of time like 1, 3, 5, 10 years to understand the consistency of returns over both short and long-term horizons.
About The Author: Reenika Avasthi is associated with Inverika Investment Solutions LLP as a Content Writer and Financial Planner. She is a Certified Financial Planner and a freelance content writer in the field of personal finance. Her interest in writing and spreading investor awareness motivated her to start blogging.
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