How important are mutual fund ratings?

Mutual fund ratings are increasingly popular with today’s investor base - especially the ones who are picking their mutual funds. With hundreds and thousands of mutual funds that exist today, ratings offer simplicity in selecting the right fund/stock.

Earlier this year - we sent out a survey to retail investors about how they select their mutual fund investments. We learned that a large proportion of investors looks at investments from 2 lenses - returns and ratings. The investments with tn/.he highest returns + highest ratings are predominantly the ones investors go for.

Selecting the highest return fund has its own set of challenges. However, for this article - let us focus on ratings. Does a 5-star rated fund offer advantages over a 4-star fund and so on? Who determines these ratings, how are they calculated, and are they useful in predicting future returns? Let us find out.

Rating agencies calculate ratings based on both qualitative and quantitative parameters.

The quantitative factors include the overall mutual fund performance, measured by parameters such as the Sharpe ratio, Treynor ratio, and alpha. Volatility and liquidity of the mutual fund scheme are other parameters that guide agencies.

Other important quantitative factors include Portfolio Concentration, followed by credit quality for debt funds.

The qualitative factors include the mutual fund’s reputation, fund manager track record, and investment process.

Mutual Fund Ratings are considered to be very important by a majority of mutual fund investors. Since many of them rely on these ratings, there are three primary reasons why they are important.

Simplification

Ratings help simplify investment decision-making by creating a simple metric that allows investors to select the right fund for their portfolio.

For example, a 5-star rated fund is superior to a 4-star fund and so on. So this helps investors make quick decisions based on simplified market data.

Elimination

Since Mutual fund ratings are calculated on both quantitative and qualitative factors, they help remove the ‘bad apples’ in the choice bucket.

This essentially includes funds with an unreliable or unsatisfactory history and overall potential. They might also help mutual fund investors avoid high-risk investments.

Changes in ratings could be a valuable source for investors who do not have the time and effort to monitor their portfolios or do not have the right skills.

A rating change could mean meaningful qualitative and qualitative changes in the fund characteristics. This could be a good or a bad thing.

Are ratings useful?

The US markets tend to have a higher history of ratings - and results from there show that ratings have been poor predictors of future performance (just like past returns).

Data shows that ratings are mostly products of hindsight bias. Hindsight bias is a psychological phenomenon that allows people to believe that they accurately predicted an event after it happened. This can lead them to think that they can accurately predict other events.

Investors who invest based on ratings should account for the hindsight bias in mutual fund ratings and dig deeper into mutual funds before investing in them.

As opposed to selecting a fund according to its star rating - investors should use ratings to remove 1-star and 2-star funds. History suggests that funds with low ratings tend to stay low for long periods. The process of elimination turns out to be a better method than using ratings as a process of selection.

There seems to be a correlation between performance and ratings. Also, - rating changes happen after good/poor performance. It is well documented that a 4-star fund gets promoted to a 5-star fund after it’s performed well and vice versa.

Investors who are only buying 5-star funds in their portfolio do not have the edge over investors with 3-4 star funds.

A lot of asset managers tend to stick to rating agency products. This may or may not affect the overall fund ratings.

Perhaps the biggest flaw in ratings is the over-simplistic system in determining what is good and bad. In the real world - some investors are young and old, investors who have different risk profiles, etc. What is suitable for a set of investors could easily be bad for other groups of investors.

Conclusion

Mutual fund ratings are not completely free of risk and bias. They must not be used as the only criteria while choosing a mutual fund to invest in.

Individuals should look at other factors such as stability of the fund house, investment philosophy, and track record of funds. Investors overall should spend some time doing more due diligence when choosing investments wisely.