We have noticed that often, investors consider a lot of parameters in isolation while making investments in mutual funds. In the past, we have delved on some of these parameters viz. past performance, fund manager, performance on compounded annualised growth rate.

In this article, we discuss another parameter that leaves investors all starry-eyed - mutual fund ratings. We have given our view on ratings and also how Morningstar, a pioneer of sorts in mutual fund ratings, considers its own ratings.

For some time now, Indian mutual fund investors have taken a fancy for star ratings that are accorded by select mutual fund research firms/agencies. These firms, based on certain pre-determined parameters, give a rating (often by way of stars, more stars means a better rating) to various mutual funds. Often the rating process is quite complicated, so we find it ironical as to how investors have taken a fancy to them without first understanding how these ratings were arrived at.

• Do the stars really foretell?

Star ratings in the Indian context don't really do justice to the funds that are rated. To begin with, the ratings are biased towards returns i.e. net asset value appreciation and even then it's only past performance. Other factors like risk, portfolio diversification, ethics, processes and investment philosophy are either given lower weightage or no weightage at all.

In our view, star ratings in most cases (at least in the Indian context) must be considered with a pinch of salt for the following reasons:

1) Since past performance has such an important role to play in the rating process, the ratings are backward-looking, not forward-looking.

• How CAGR can be misleading

2) Given that returns are a key constituent in the ratings, other factors being the same, a change in the returns usually results in a revision in the rating. For investors, it can be a nightmare to realign their investments in a mutual fund in response to the latest revision in its rating.

3) The ratings do not accord adequate priority to investment processes pursued by a mutual fund. A mutual fund based on its processes may register a certain performance level which may not compare well to another mutual fund, with a superior performance on the back of a star fund manager. In our view, there is a higher risk associated with the mutual fund with a star fund manager that the ratings simply fail to capture. When the star fund manager quits, the mutual fund is left in the lurch and this is most likely to show in its performance. The ratings usually fail to highlight this to the investor.

4) The ratings also fail to highlight the importance of ethics. A fund house (or its star fund manager) that is embroiled in a scam/financial irregularity does not get a `negative rating' on ethics. So a fund house that is performing well on the returns front, although it has been hauled up by regulators for misdemeanours while investing, will still manage to get a high rating based on high returns, albeit at lower ethics. So there is a need to accord an `ethics-adjusted return' which ratings fail to do.

5) Most ratings also ignore transparency and compliance in terms of information flow to investors. A mutual fund that does not give adequate and relevant information to investors in a timely and consistent manner will nonetheless rank highly based on its superior performance. So there are no negative ratings for being investor-unfriendly and no plus points for being investor-friendly.

6) Ratings fail to tell an investor whether or not he should be investing in a fund. There could be a dozen equity funds in a particular peer group, all with 5 star ratings. How is the investor supposed to know, which is the best fund for him? The ratings fail to guide investors on exactly which fund is ideal for their portfolios.

While in India ratings are considered by investors and the rating agencies as fairly conclusive, we would like to draw the attention of our visitors towards how Morningstar, the father of mutual fund ratings, so to speak, considers its own ratings. Morningstar is an international firm that researches mutual funds and stocks. This is what Morningstar has to say about its own ratings:

"As always the Morningstar Rating is intended for use as a first step in the fund evaluation process. A high rating alone is not sufficient basis for investment decisions."

In our view, this is exactly how these ratings must be treated. They are at best a starting point for investors. They are certainly not the be-all and end-all of mutual fund evaluation. This is a point for consideration for all parties involved - the rating agency that gives the rating, the mutual fund that showcases them and the investor who is impressed by them.

By Personalfn.com, a financial planning initiative
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