Today, you, a mutual fund investor are overwhelmed with the plethora of mutual fund schemes. More so when you find that schemes from different fund houses come with similar flavours. It becomes extremely difficult for you actually to sift the bad ones from the good ones. Then what do you do?
You take help of rating of mutual funds issued by various mutual fund rating agencies, such as Morningstar, Value Research and ICRA. CARE and CRISIL also rank mutual fund schemes. But is ‘mutual fund ratings' the final parameter to be taken in to consideration for investment?
What is Mutual Fund Rating?
Mutual fund rating agencies generally rate mutual funds based on the fund's past performance, the fund manager's skill, risk- and cost-adjusted returns, and performance consistency. These mutual fund ratings are designed to help investors quickly identify mutual funds to consider purchasing for their investment portfolios.
Do better mutual fund ratings mean better returns?
Mutual fund ratings by themselves do not guarantee better returns in the future. However, over a period of time better rated mutual funds do perform better than the lower rated ones. But there are always exceptions. Sometimes, lower rated mutual fund schemes may outperform higher rated ones. The chances of a 5 star rated mutual fund going out of rating is very low compared to a 1-2 star rated one.
Mutual Fund Ratings: A Backward-looking Mechanism
Mutual fund ratings are intended to be a starting point for further research and are not buy or sell recommendations. However, these mutual fund rating suffer one severe limitation that they are a backward-looking assessment mechanism, which does not reflect the rating agency's opinion of the future potential of a fund.
Mutual Fund Rating agencies also suggest that their mutual fund ratings look backwards and since past performance is no guarantee for the future, they should be considered only as a filtering mechanism in the process of selecting a mutual fund.
Mutual Fund Ratings and Financial Goals:
Mutual fund ratings are generic. As an investor you should not invest in all top rated funds. We don't go to a pharmacy and ask for the best medicines. We need to choose medicine based on our requirement.
Similarly, you need to choose mutual fund categories which will help you meet your financial goals. Then in that category of mutual funds, you can look out for top rated mutual funds.
Choosing a suitable category of mutual fund (equity diversified, balanced, income) should take precedence over the search for mutual fund rating. The mutual fund rating would be of no use if one chooses an inappropriate category in the first place.
Beyond Mutual Fund Ratings:
Experts in the field say that mutual fund rating alone cannot be used as a tool for decision-making while investing in a mutual fund.
One must also look at the:
- Ability and stability of the fund house,
- Track Record and Retention of the fund manager
- Strong internal investment process
- Integrity of the mutual fund house.
Mutual fund ratings serve as a foundation for you on which to base your search, but should not be used as a benchmark. You have to exercise more due diligence to select the right mutual fund.
The mutual fund ratings primarily help avoid the lousy funds as indicated by the lower mutual fund ratings. You should not, therefore, take a short sighted view on mutual fund ratings and take into consideration other important factors like consistent performance, expenses, fund manager's track record and experience as well as the fund house reputation.
The author is Ramalingam K, CFP CM is the Chief Financial Planner at holisticinvestment.in, a leading Financial Planning and Wealth Management company.