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When investing in mutual funds, it has become the norm to look at the star ratings awarded to the particular fund. People choose funds on the basis of the stars earned by them. But do you know stars are not the indictors of the best funds? Why is that so? Today it has become the norm for mutual funds to advertise their products in the media by highlighting the stars they have been awarded. Many financial advisors also highlight this aspect to their clients in order to influence them to invest in funds that offer them the highest commission. But the fact is that star ratings in the Indian scenario do not give complete information about a mutual fund. Here is why they are totally irrelevant to you as an investor: -
Mutual fund ratings are based on the returns generated, that is, appreciation of net asset value, based on the historical performance. So they rely more on the past, rather than the current scenario.
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As returns play a key role in deciding the ratings, any change in returns will lead to re-rating of the mutual fund. If you choose your mutual fund only on the basis of rating, it will be a nuisance to keep realigning your investment in line with the revision of the ratings.
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The ratings don’t value the investment processes followed by the mutual fund. As a result, a fund following a certain process may lose out to a fund that has given superior returns only because it has a star fund manager. But there is a higher risk associated with a star fund manager that the ratings don’t reflect. If the star fund manager quits, it can throw the working of a mutual fund out of gear and thus affect its performance.
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The ratings don’t show the level of ethics followed by the fund. A fund or fund manager that is involved in a scam or financial irregularities won’t get poor ratings on the basis of ethics. As the star ratings look at just returns, any wrongdoing carried out by the fund or fund manager will be completely ignored.
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Ratings also don’t consider two very important factors: transparency and keeping investors informed. There are no negative ratings awarded to the fund for being investor-unfriendly.
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Ratings don’t match the investor’s risk-appetite with their portfolio. As a matter of fact, investments should be done only after considering the risk appetite of the investor. For example, equities may not be the best investment vehicle for a very conservative investor. However ratings fail to take that into account.
Ratings should be the starting point for making an investment decision. They are not the be all and end all of mutual fund investments. There are other important factors like portfolio management, age of funds and more, which should be taken into account before making an investment.
Have you ever invested in a mutual fund only on the basis of its ratings? Did it pay off or did you lose money on your investment? What happened when the ratings changed? We would like to hear from you. You may also be interested in :
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