Mutual Fund Ratings A Myth Or Veracity?

Authors : Mr. Prakash M walavalkar, Dr. Shivashankar k, Dr. Anilkumar G Garag 

Abstract:

Mutual fund rating are in vogue for the past many years, although the ratings indicate that the mutual funds are performing well, or otherwise, the ranking for the Mutual Fund alone cannot be a decision-making method when investing in a mutual fund, since mutual funds are based on past performance and it may fail to continue the future. The mutual fund investor must look at the capability and consistency of the fund house, longevity of the fund manager, the good internal investment mechanism, the track record, the reputation of a house of the mutual fund, etc. Mutual fund ratings serve as a basis for the search, but should not be used as a benchmark. The mutual fund investor must exert due diligence to pick the correct mutual fund.

Keywords: Mutual funds, Mutual fund rating

Introduction:

The multitude of mutual funds schemes overwhelms mutual fund investors. Moreover, if you find the schemes from various funds have similar flavors. Sifting bad ones from the good ones is incredibly difficult. Investors of mutual funds are supported by rating mutual funds provided by different mutual fund rating agencies such as Value research, ICRA, Morningstar, CARE, CRISIL, etc. Mutual fund rating agencies usually rate mutual funds based on the past performance of the fund, expertise of the fund manager, risk and cost-adjustment level of the fund, and quality of performance. The ratings of the mutual fund mainly avoid the awful funds, as shown by the lower ratings of the mutual funds, so the investor should be aware. Do better ratings for mutual funds mean improved returns? There are issues in the minds of mutual fund investors that lead to myth or veracity.

Mutual Fund ratings:

Ratings of mutual funds assist the investors to assess the best funds quickly before they go for acquiring various portfolios. Ratings of mutual funds never assure fare returns in the future. Over a while, good ranked mutual funds perform better than low ranked, but it also considers some exclusions. In certain conditions, even low ranked funds may outperform due to market changes, and similarly best ranked may show the least performance. Mutual fund ratings are meant to be a starting point for further study and are not meant to buy or sell recommendations. However, the ratings are severely restricted because of the method of retroactive evaluation that does not represent the opinion of the rating agency on its potential in the future.

Many Mutual Fund rating agencies often say that the ratings of their mutual fund are backward oriented as past performance does not guarantee future results, they can only be considered as a screening mechanism for a mutual fund selection. The investor can invest in high rated funds on a requirement basis to select categories of mutual funds that will lead to the achievement of financial aims. When an incorrect category is selected, the mutual fund ranking will not be beneficial. The first piece of information to be measured for mutual fund results is the returns of the fund, compared to its corresponding benchmark index. For instance, it's best to compare it with the average return on investment for the corresponding category if the investor wants to see how well the mutual fund has performed.

The emphasis should be on the Mutual Fund 's five and ten-year terms. Because some fund managers will often have a bad year, fund managers will often have to change in certain financial environments. Given that the different types of fund managers are being promoted and the market conditions continually change, it is prudent to evaluate the capabilities of the fund manager and therefore the success of a specific fund manager by analyzing periods that span various economic environments.

The various periods that can be considered for mutual fund performance evaluations include the 1,3, 5, & 10-year returns respectively. If more prominence is given to the most relevant performance periods and less prominence on the less relevant performance periods, mutual fund expert put forward weighting the 5-year heaviest, followed by the 10-year, then 3-year, and 1-year last. As an example, we can consider the mutual fund evaluation system based upon 0.4 weight to the 5-year performance, a 0.3 weight to the 10-year performance, a 0.2 weight to the 3-year performance, and a 0.1 weight to the 1-year performance, subsequently, the mutual fund investor can multiply the weights by each corresponding return for the given periods and take the average of the totals to identify the better performing mutual funds, however, the tenure of managers must also be assessed at the same time as the success of the fund. A good 5-year return, for instance, does not mean anything when the fund manager is at the helm just 1 year ago. Similarly, if the annualized 10-year return is below the average relative to the other group funds, but the output of the 3-year duration looks fine, this fund may be taken into consideration if the management tenure is about 3 years. This is because the present manager of the fund is credited with the strong returns for 3 years but he is not completely responsible for the low returns for 10 years. Morningstar has stated that “We have always been very clear that it’s not intended to predict future performance.” Also, the Morningstar's CEO asserts similar ideas "We recognize and have often acknowledged the limitations of a measure like a star rating that’s based on past performance, but we also believe it can usefully tilt the odds in investors’ favor when combined with other research and tools. We’ve long described the star rating as a worthwhile starting point for research that can help investors make good decisions when combined with other research and tools.” Similarly, Value research has stated, “The assessment does not reflect Value Research’s opinion of the future potential of any fund. It only gives a quick summary of how a fund has performed historically relative to its peers.” Both the rating agencies, namely Morningstar and Value Research Online also show that star ratings are completely statistical, and reflect the risk-adjusted return of a fund over the last three and five years, with the best performers earning 5 Stars.

There is an overwhelming and superfluous number of mutual funds available in the industry and most mutual fund investors do not understand how to choose the right mutual fund schemes, hence they, take the straightforward way out and rely on the mutual fund star ratings. In Morningstar 's words, “the star rating system ‘is a way to whittle down a big universe into something more manageable.” The Mutual fund star ratings are designed to help investors identify funds for investment. Initially, the investors are given a fast and detailed view of the selected fund within minutes, this is ideal for this era of time-poverty. Yet it is difficult for investors to rely solely on this ranking to collect funds. Such stars are viewed as a reference to potential success and a high star rating as a definite purchase signal. This is not the way to go. However, over a while, higher-rated mutual funds are usually expected to perform better than lower ones. Yet there are also cases in which lower-rated funds are higher. Such investors must wake up and understand that star ratings are not adequate. It is a simple way for financial advisors to use star scores to validate their recommendations. To pick each other, these values can at best be treated as a sort of filtering mechanism for selecting mutual funds for investment. If necessary, the mutual fund investors should use only this rating data as their starting point and combine it with other key factors like effectiveness, investment objective, consistency, mutual fund focus, expenses, portfolio, track records and experience of the mutual fund manager, benchmark, the investment process followed, the fund house’s integrity, etc. for the selection, Some of the key factors are as discussed below:

Mutual fund Investment objective: The Co-founder of Sqrrl Mr. Samant Sikka expressed his view that it’s important to have a clearly defined investment objective as then the mutual fund investor will be in a position to analyze the risk appetite. “A lot of investors are satisfied with investing in low-risk, low-return schemes, while a lot of others are okay to endure short-term losses to maximize long-term potential gains. Be it short term, long term, or concerned with a specific investment goal, having a clear investment objective will define the kind of investment that’d be well suited for the mutual fund inestor” he said.

Mutual fund expense ratio (TER): Mutual Fund expense ratio can adversely affect returns from the mutual fund, and it is highly necessary to know how much it is, and what expense ratio is acceptable. In general, experts in the mutual fund industry say the investment ratio up to 1.5% is appropriate. And while the effect on good mutual funds may not be that high, the returns can be immensely compensated as soon as the funds start to perform poorly.

Mutual Fund Benchmark: The reason as to why the benchmark index should be an important base for the mutual fund investor, is that it provides an idea as to how the fund has performed, in contrast to its benchmark index, generally the actively managed mutual fund beat its benchmark index, and in such case, the mutual fund investor should tick the box. Even when the mutual fund returns are in range with the benchmark index, it cannot be considered as a very striking proposition, outperforming the benchmark index is very necessary.

Mutual Fund manager: Samant Sikka, Co-founder Sqrrl quoted that no matter how well the mutual fund investor tries to explore the mutual fund industry, it’s ultimately the fund manager, upon whose proficiency, the mutual fund investor will depend to generate good returns on investment. And due to this exact reason, it becomes extremely important to gauge the mutual fund manager of the scheme under consideration. “Things such as past performance and the performance of the other funds in his portfolio could be good parameters to understand the competency of the fund manager,” he added.

Another issue is that different approaches (investment portfolio funds) or models are preferred and make a comeback a few years later. So the investor exits a fund that has fallen due to its unique reasons, the investor will probably miss out when the plan comes back with ablaze. The Wall Street Journal claimed in an article that the high-ranking mutual funds attracted a lot of the money of the investors in the United States of America, but most of them did not keep doing so. A highly rated mutual fund will draw more investments if it is strategically approached by the mutual fund to consultants and investors. It is easy for investors to spend new money on top-rated mutual funds even if their performance tends to decline over a period of time, since the ratings continue to be high during the overall evaluation period. Due to a continued rally in Indian equities for the past numerous years, equity has no doubt turned out to be a very attractive asset class. During these times, it’s all the more necessary that the roles of mutual fund rating agencies are evaluated in a critical and subjective manner.

Conclusion:

If the mutual fund ratings cannot predict the future returns, and the mutual fund rating agencies suggest a universal disclaimer that mutual fund ratings are not predictive, then why do the mutual fund ratings tend to become such an integral part of the Mutual Fund ecosystem? The answer to this question lies in the human psychology, as in no one ever blamed an advisor or a broker for recommending a 5-star mutual fund since, if the fund underperforms, they can easily get away by quoting that ‘well no saw that coming in the future’, but if the mutual fund advisor picks a lower-rated mutual fund and it underperforms, then the mutual fund advisor is classified as a bad advisor. Hence, the mutual fund ratings act as both a safety net as well as a shiny badge for the advisors to promote themselves to the investor. Since most mutual fund advisors go with the grain and recommend 5-star rated mutual funds, these mutual funds have seen huge inflows creating reasons for AMC with such funds to unofficially bless the mutual fund ratings in their investor materials, thus, the make-believe of the Mutual Fund star rating tends to continue. Since most mutual fund rating entities are professionally run and most information is in the public domain, the likelihood of wrongdoing appears to be limited, mutual fund ratings can be reiterated as a concept and offer useful insights into a fund, its performance in the past and the investment. However, they are not meant to be used alone or as a predictive measure. The mutual fund should be the ‘Right' mutual fund in the right category rather than being in the 'best' mutual fund of the wrong category. Alike the returns, maybe the ratings should also come with their disclosure, “Ratings are subject to market risk and past ratings do not predict future performance.”

The Wall Street Journal, stated in a study called "The Morningstar Mirage" that, "Investors everywhere think a 5-star rating from Morningstar means a mutual fund will be a top performer—it doesn't." A comparable study conducted by Advisor Perspectives found that the probability of a randomly selected 5-star mutual fund outperforming a randomly selected 4-star mutual fund is 0.56, which is as good as a coin flip.

Finally, we can conclude with the Wall Street Journal piece, “Advisers get in trouble when they go against the grain. You isolate yourself more if you sell something else rather than just go with what research recommends.” If the mutual fund investor goes through all the articles related to this particular discussion, it is understood that the rating agencies also know about the inadequacy of the mutual fund star ratings but they have to sustain by running the business.